Strategic management Ch 10 Corporate Governance Lecture

8/3/2019 Strategic management Ch 10 Corporate Governance Lecture

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Hitt Chapter 10Corporate Governance

MGNT428

Business Policy & StrategyDr. Gar Wiggs,Instructor



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Knowledge Objectives

• Studying this chapter should provide you with the strategic management knowledge needed to:

– Define corporate governance and explain why it is used to monitor and control managers’ strategic decisions.

– Explain why ownership has been largely separated from managerial control in the modern corporation.

– Define an agency relationship and managerial opportunism and

describe their strategic implications. – Explain how three internal governance mechanisms —ownership

concentration, the board of directors, and executive compensation —are used to monitor and control managerial decisions.



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Knowledge Objectives (cont’d)

• Studying this chapter should provide you with the strategic management knowledge needed to:

Discuss the types of compensation executives receive and their effects on strategic decisions.

Describe how the external corporate governance mechanism —the market for corporate control —acts as a

restraint on top- level managers’ strategic decisions. Discuss the use of corporate governance in international

settings, in particular in Germany and Japan.

Describe how corporate governance fosters ethical strategic decisions and the importance of such behaviors on the part of top-level executives.



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Corporate Governance

• Corporate governance is:

– A relationship among stakeholders used todetermine and control the strategic direction

and performance of organizations

– Concerned with making strategic decisionsmore effectively

– Used to establish order between a firm’sowners and its top-level managers whoseinterests may be in conflict



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Internal GovernanceMechanisms

• Ownership Concentration – Relative amounts of stock owned

by individual shareholders and

institutional investors• Board of Directors

– Individuals responsiblefor representing the firm’s

owners by monitoring top-levelmanagers’ strategic decisions



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Internal Governance Mechanisms

• Executive Compensation

– Use of salary, bonuses, andlong-term incentives to align

managers’ interests withshareholders’ interests



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External Governance Mechanisms

• Market for CorporateControl

– Purchase of a firm that is

underperforming relative toindustry rivals in order toimprove its strategic

competitiveness



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Separation of Ownership and

Managerial Control• Basis of the Modern Corporation

– Shareholders purchase stock, becoming

residual claimants

– Shareholders reduce risk by holdingdiversified portfolios

– Professional managers are contracted toprovide decision making



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Separating Ownership and

Managerial Control• Modern public corporation form leads to

efficient specialization of tasks:

– Risk bearing by shareholders

– Strategy development and decision making bymanagers



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An Agency Relationship

Figure 10.1

Hire

and create



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Agency Relationship Problems

• Principal and agent have divergent interests andgoals

• 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 toverify that the agent has behaved appropriately

• Agent falls prey to managerial opportunism



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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 themaximization of shareholder wealth (theprimary goal of owner/principals)



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Response to ManagerialOpportunism

• Principals do not know beforehand whichagents will or will not act opportunistically

• Thus, principals establish governance andcontrol mechanisms to prevent managerialopportunism



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Examples of the Agency Problem

• Possible Problems – Product diversification

– Increased size, and relationship of size to managerial

compensation – Reduction of managerial employment risk

• Use of Free Cash Flows

– Managers prefer to invest these funds in additionalproduct diversification (see above)

– Shareholders prefer the funds as dividends so theycontrol how the funds are invested



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Manager and Shareholder Risk and

Diversification

Figure 10.2



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Agency Costs and GovernanceMechanisms

• Principals may engage in monitoringbehavior to assess the activities anddecisions 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



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Governance Mechanisms

• Large block shareholdershave a strong incentive tomonitor management

closely: – Their large stakes make it worththeir while to spend time, effort andexpense to monitor closely

– They may also obtain Board seatswhich enhances their ability to

monitor effectively

• Financial institutions arelegally forbidden fromdirectly holding board seats

OwnershipConcentration (a)



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Governance Mechanisms (cont’d)

• The increasing influence ofinstitutional owners (stockmutual 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

OwnershipConcentration (b)



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• Shareholder activism:

– Shareholders can convene todiscuss corporation’s direction

– If a consensus exists,shareholders can vote as ablock to elect their candidatesto the board

– Proxy fights – There are limits on

shareholder activism availableto institutional owners in

responding to activists’ tactics

OwnershipConcentration (c)



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• 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 managerialopportunism

OwnershipConcentration

Board of Directors

(a)



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• Composition of Boards: – Insiders: the firm’s CEO and

other top-level managers

– Related Outsiders: individuals

uninvolved with day-to-dayoperations, but who have arelationship with the firm

– Outsiders: individuals who

are independent of the firm’sday-to-day operations andother relationships


Board of Directors(b)



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• Criticisms of Boards ofDirectors include: – Too readily approve managers’ self -

serving initiatives

– Are exploited by managers withpersonal ties to board members

– Are not vigilant enough in hiring andmonitoring CEO behavior

– Lack of agreement about the

number of and most appropriaterole of outside directors


Board of Directors(c)



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• Enhancing the effectivenessof boards and directors: – More diversity in the backgrounds

of board members – Stronger internal management and

accounting control systems

– More formal processes to evaluatethe board’s performance

– Adopting a “lead director” role – Changes in compensation of

directors


Board of Directors(d)



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• Forms of compensation: – Salary, bonuses, long-term

performance incentives, stockawards, stock options

• Factors complicatingexecutive compensation: – Strategic decisions by top-level

managers are complex, non-routine

and affect the firm over an extendedperiod

– Other variables affecting the firm’s

performance over time


Board of Directors

Executive

Compensation (a)



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• Limits on the effectivenessof executive compensation:

– Unintended consequences ofstock options

– Firm performance not asimportant than firm size

– Balance sheet not showingexecutive wealth

– Options not expensed at thetime they are awarded


Board of Directors

Executive

Compensation (b)



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• Individuals and firms buy ortake over undervaluedcorporations – Ineffective managers are usually

replaced in such takeovers

• Threat of takeover maylead firm to operate moreefficiently

• Changes in regulationshave made hostiletakeovers difficult


Board of Directors

Executive

Compensation

Market forCorporate Control (a)



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Governance Mechanisms(cont’d) • Managerial defense tactics

increase the costs ofmounting a takeover

• Defense tactics mayrequire:

– Asset restructuring

– Changes in the financialstructure of the firm

– Shareholder approval

• Market for corporate

control lacks the precision


Board of Directors

Executive

Compensation

Market forCorporate Control (b)



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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 lessemphasis on shareholder value

than in U.S. firms, although thismay be changing



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Responsible for the functionsof direction and management

Responsible for appointingmembers to the Vorstand

Responsible for appointingmembers to the Aufsichtsrat

International Corporate Governance

Vorstand

Aufsichtsrat

Employees Unionmembers

Shareholders

Germany: (Two-tiered Board)



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International Corporate Governance:

• Japan – Important governance factors:

• Obligation

• “Family” • Consensus

– Banks (especially “main

bank”) are highly influential with

firm’s managers

– Keiretsus: strongly interrelated

groups of firms tied together bycross-shareholdings



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International Corporate Governance

• Japan (cont’d)

– Other governance characteristics:

• Powerful government intervention

• Close relationships between firms andgovernment sectors

• Passive and stable shareholders who exert

little control• Virtual absence of external market for

corporate control



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Capital Market

Stakeholders

Governance Mechanisms and

Ethical BehaviorIt is important to serve the interests of thefirm’s multiple stakeholder groups!

• Shareholders in this group are

viewed as the most importantstakeholder group

• The focus of governancemechanisms is to control

managerial decisions to assureshareholder interests

• Interests of shareholders isserved by the Board of Directors



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Product MarketStakeholders

Governance Mechanisms andEthical Behavior (cont’d)

• Product market stakeholders

(customers, suppliers and hostcommunities) andorganizational stakeholdersmay withdraw their support of

the firm if their needs are notmet, at least minimally

Capital Market

Stakeholders

It is important to serve the interests of thefirm’s multiple stakeholder groups!



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Organizational

Stakeholders

Governance Mechanisms andEthical Behavior (cont’d)

• Some observers believe that

ethically responsible companiesdesign and use governancemechanisms that serve allstakeholders’ interests

• Importance of maintainingethical behavior is seen in theexamples of Enron, WorldCom,HealthSouth, Tyco, Adelphi, andAhold NV

Product MarketStakeholders

Capital Market

Stakeholders

It is important to serve the interests of thefirm’s multiple stakeholder groups!

Documents

Strategic management Ch 10 Corporate Governance Lecture