Corporate Governance

Chapter 10: Corporate Governance
Chapter 10
Corporate Governance
KNOWLEDGE OBJECTIVES
1. Define corporate governance and explain why it is used to monitor and control managers strategic
decisions.
2. Explain why ownership has been largely separated from managerial control in the modern corporation.
3. Define an agency relationship and managerial opportunism and describe their strategic implications.
4. Explain how three internal governance mechanismsownership concentration! the board of directors! and
executive compensationare used to monitor and control managerial decisions.
". Discuss the types of compensation executives receive and their effects on strategic decisions.
#. Describe how the external corporate governance mechanismthe mar$et for corporate controlacts as a
restraint on top%level managers strategic decisions.
&. Discuss the use of corporate governance in international settings! especially in 'ermany and (apan.
). Describe how corporate governance fosters ethical strategic decisions and the importance of such behaviors
on the part of top%level executives.
CHAPTER OUTLINE
Opening Case How Has Increasingly Intensive Corporate Governance Affected the Lives of CEOs?
*E+,-,./01 02 031E-*4/+ ,1D 5,1,'E-/,6 701.-06
,gency -elationships
+roduct Diversification as an Example of an ,gency +roblem
,gency 7osts and 'overnance 5echanisms
031E-*4/+ 7017E1.-,./01
.he 'rowing /nfluence of /nstitutional 0wners
80,-D 02 D/-E7.0-*
Enhancing the Effectiveness of the 8oard of Directors
E9E7:./;E 705+E1*,./01
trategic !oc"s Executive 7ompensation /s /ncreasingly 8ecoming a .arget for 5edia! ,ctivist
*hareholders! and 'overnment -egulators
.he Effectiveness of Executive 7ompensation
5,-<E. 20- 70-+0-,.E 701.-06
5anagerial Defense .actics
/1.E-1,./01,6 70-+0-,.E '0;E-1,17E
7orporate 'overnance in 'ermany
7orporate 'overnance in (apan
trategic !oc"s *hareholder ,ctivists /nvade (apans 6arge 2irms .raditionally 2ocused on
=*hareholder> 7apitalism
'lobal 7orporate 'overnance
'0;E-1,17E 5E74,1/*5* ,1D E.4/7,6 8E4,;/0-
*:55,-?
-E;/E3 @:E*./01*
E9+E-/E1./,6 E9E-7/*E*
10.E*
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LECTURE NOTES
Chapter Introduction: The purpose of this chapter is to present and discuss how
shareholders (owners) can ensure that managers develop and implement strategic decisions
in the best interests of the shareholders (owners) and not be primarily self-serving (working
for the best interests of managers only, to the detriment of shareholders). In the absence of
effective internal governance mechanisms, the market for corporate controlan e!ternal
governance mechanismmay be activated. "hile it is a sub#ect most fre$uently associated
with firms in the %.&. and the %.'., the effectiveness of governance is gaining attention
throughout the world. The chapter begins by describing the relationship that provides the
foundation on which the modern corporation is builti.e., the relationship between owners
and managers. (owever, the ma#ority of this chapter is devoted to an e!planation of various
mechanisms owners use to govern managers and ensure ma!imi)ation of shareholder value.
OPENING FOCUS
How Has Increasin!" In#ensi$e Cor%ora#e Go$ernance A&&ec#e' #(e Li$es o& CEOs)
,lthough corporate governance is a necessity! it is also important to ma$e sure itBs executed properly to
avoid the problems and pitfalls associated with expectations of 7E0 behavior and performance that have
evolved as a result of greater scrutiny. /n 2AA#! a record number of 7E0s left their Cobs. .his exodus is
due in part to increasing scrutiny by boards! governance activists! and increased pressure from the mar$et
for corporate control as board members are pressured to challenge the views of the 7E0 if they appear to
be headed in a direction that will not benefit all sta$eholders.
.he *arbanes%0xley legislation Dpassed in 2AA2E caused :.*. corporate governance policies to be more
intense. .his scrutiny translates into a Fero tolerance for any form of corruption! conflict of interest! or
other forms of wrongdoing or inappropriate behavior. 8ut this scrutiny may have a price. .he average
tenure for 7E0s is now down to 1)%24 months because so many new 7E0 are in place. /f this trend
continues! Harvard #"siness $eview reports that nearly half of the largest :.*. firms will have a new 7E0
in the next four years. 8ecause of the high turnover and shorter tenures! 7E0s are focusing more and more
on short%term turnaround corporate strategies and contractually loo$ing to their inevitable departure.
/ronically! the increases in governance controls have led to an increase in 7E0 pay and severance per$s!
including golden parachutes that often pay three years of annual salary if a 7E0 exits before hisGher
contract expires because the firm is ta$en over. /f the *E7 sets a limit on exit pay! 7E0s will li$ely arrange
more pay upfront to compensate for the ris$s they are ta$ing! given the shorter 7E0 tenures in most firms.
,uthor (im 7ollins found that inside 7E0s have been able to provide leadership that allows firms to realiFe
longer%term profitability and above average returns! but it ta$es about seven years in place to affect
profitability. 8ut the abbreviating of average 7E0 tenure will not accommodate this window since they are
leaving their Cobs before that are reaching their maximum effectiveness. .hus! corporate governance is a
double%edged sword. 0n the one hand! it is necessary to put an end to scandals such as the Enron disaster!
which led to a significant loss for all sta$eholders involved! including employees. ,lso! 7E0 compensation
is Huite excessive relative to other managers and employees. 0n the other hand! governance that is overly
restrictive can reduce managerial ris$ ta$ing and increase governance costs excessively! as well as
constrain the 7E0s decision%ma$ing authority. /ronically! it inadvertently leads to increased pay for
7E0s! which many governance activists rail against. ,lthough corporate governance is a necessity! it is
also important to ma$e sure that it is executed properly to avoid the problems noted here.
*ive your students a chance to do their +thing, with this opening case. This case can best be
described as a paradox. Is it a case of +be careful what you ask for-, .r maybe it/s an e!ample
of +ready, fire, aim0, 1llow students to voice their opinions2 allow others to rebut. 3ou may end
up with a +food fight.,
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*
Define corporate governance and explain why it is used to
monitor and control managers strategic decisions.
Corporate governance is a relationship among sta$eholders that is used to determine and control the direction
and performance of organiFations. ,t its core! corporate governance is concerned with identifying ways to
ensure that strategic decisions are made effectively.
7orporate governance has been emphasiFed in recent years because! as the 0pening 7ase illustrates! corporate
governance mechanisms increasingly affect all sta$eholders and the firmBs future.
Effective corporate governance is also of interest to nations. 'overnments want firms operating within their
countries to grow and provide employment! wealth! and satisfaction. .his raises standards of living and
enhances social cohesion.
.hree internal governance mechanisms examined here are D1E ownership concentration! as represented by types
of shareholders and their different incentives to monitor managers! D2E the board of directors! and D3E executive
compensation. .he external governance mechanism is the mar$et for corporate control.
Teaching Note: In the chapter, corporate governance is discussed from two perspectives:
The primary purpose of governance mechanisms is to prevent severe problems that may
occur because of the separation of ownership and control in large firms by positively
influencing managerial behavior.
The ability of governance mechanisms to direct top mangers/ actions toward shareholder
ob#ectives is dependent on the correct combination of mechanisms being used.
+
Explain why ownership has been largely separated from
managerial control in the modern corporation.
SEPARATION OF OWNERSHIP AND ,ANAGERIAL CONTROL
.he growth of the large! modern public corporation is based primarily on the efficient separation of ownership
and managerial control.
*hareholders ma$e investments by purchasing stoc$ Drepresenting ownershipE! which entitles them to a share of
the firms residual income Dor profitsE that remain after all expenses have been paid.
.he right to share in residual income also means that shareholders also must accept the ris$ that no residual
profits will remain if the firms expenses exceed its income.
*hareholders can manage investment ris$ by investing in a diversified portfolio of firms.
/n small firms! managers and owners are often one in the sameless separation of ownership and control.
,s family%controlled firms grow! the owners generally do not have sufficient capital or managerial s$ills to
grow the business and see$ other sources of capital and s$ills to support this expansion.
Teaching Note: It is helpful to provide a story that would illustrate what the separation of
ownership and managerial control is all about, and how it came to be. 4or e!ample, it is easy
for students to see that (enry 4ord was involved in both the ownership and the operation of
4ord 5otor 6ompany in the early days. They can see in their minds the old footage of 5odel
T/s coming off a very crude assembly line, by today/s standards, and understand how much
simpler operations were at the time. That has all changed with the advent of the modern,
comple! corporation. Today there is almost no way to bring ownership and managerial
control back together again in a workable model.
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-
Define an agency relationship and managerial opportunism
and describe their strategic implications.
Aenc" Re!a#ions(i%s
3hile the efficient separation of ownership and control enables specialiFation both by owners and managers! it
also results in some potential costs Dand ris$sE for owners by creating an agency relationship.
,n aenc" re!a#ions(i% exists when one party Dthe principalIsJE delegates decision ma$ing to another party Dthe
agentIsJE in return for compensation as a decision%ma$ing specialist who performs a service. .his relationship
can be broader than Cust owners and managerse.g.! consultants and clients or insured and insurer.
Figure Note: Figure 10.1 illustrates how separation of ownership from control results in an
agency relationship and is very helpful in getting students to understand the issues involved.

FIGURE 10.1
An Aenc" Re!a#ions(i%
1ote the following in the figure D!ig"re 10%1EK
*hareholders DprincipalsE hire managers DagentsE as decision ma$ers.
.he hiring act creates an agency relationship wherein a ris$%bearing specialist DprincipalE compensates
a managerial decision%ma$ing specialist DagentE.
.he potential for conflicts of interests between owners and managers is created by the delegation of the
responsibilities of decision ma$ing to managers. .herefore! managers may ta$e actions that are not in the best
interests of owners by selecting strategic alternatives that serve managerial interests rather than shareholder or
owner interests.
,n agency relationship enables the possibility of managerial opportunism! the see$ing of self%interest with
guile Di.e.! with cunning or deceitE! where opportunism is represented by an attitude or inclination and a set of
behaviors.
8efore observing the results of decisions! it is impossible to $now which agents will behave opportunistically
and which ones will not because a managers reputation is an imperfect guide to future behavior. ,s a result!
principals establish governance and control mechanisms because the opportunity for opportunistic behavior and
conflicts of interest exists.
Pro'.c# Di$ersi&ica#ion As an E/a0%!e o& an Aenc" Pro1!e0
+roduct diversificationdiscussed in 7hapter #can be beneficial to both shareholders and managers! but it
also is a potential source of agency problems.
5anagers may pursue higher levels of product diversification than are desired by shareholders to capture the
value of opportunities that are available to managers! but not to owners.
/ncreased diversification generally drives the growth of the firm and firm growth is positively related to
managerial compensation. .hus! by diversifying to a greater extent than may be desired by shareholders!
managers may enCoy the higher levels of compensation that accompany managing larger firms.
/ncreased diversification also can reduce managerial employment risk Dthe ris$ of Cob loss! loss of
compensation! or loss of managerial reputationE. /ncreased diversification reduces managerial employment
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ris$ because the firm Dand the managerE is less affected by a reduction in demand for Dor failure ofE a single
product line when the firm produces and sells multiple products.
/ncreased diversification also may provide managers with access to increased levels of slac$ resources or
free cash flows! resources that are generated after investment in all internal proCects that have positive net
present values within the firms current product lines. 5anagers may choose to invest excess funds in
products or activities that are not related to the firms existing core businesses and products if they perceive
attractive Dpositive net present valueE investment opportunities.
Figure Note: Figure 10.2 illustrates the variance between the risk profiles of shareholders
and managers based on the level or type of firm diversification. It shows that owners may
benefit from managers/ decisions to diversify the firm/s products, but only to the point where
investment returns at the margin are no longer positive. That is, diversification is valuable to
(and preferred by) owners as long as it has a positive effect on firm value. (owever, some
firms may be overdiversified, despite the lack of profitability in their dominant business.
.wners also may prefer that e!cess funds be returned to them in the form of dividends so
they can control reinvestment decisions.
FIGURE 10.
,anaer an' S(are(o!'er Ris2 an' Di$ersi&ica#ion
7urve * represents the business or investment ris$ profile for shareholders DownersE. /t spans a diversification
scope from dominant business Dwhich would be to the left of related%constrainedE to a point between related%
constrained and related%lin$ed diversification. .he optimum ris$ level is at point ,! between dominant business
and related%constrained diversification.
7urve 5 represents the managerial employment ris$ profile. /t spans a diversification profile from related%
constrained to unrelated diversification. .he optimum diversification level for managers is point 8! between
related%lin$ed and unrelated businesses.
,s illustrated by the *%curve Downer business ris$ preferenceE and 5%curve Dmanagerial employment ris$
preferenceE! there is a conflict between owners and managers regarding the desired levels of firm diversification
and ris$.
0wners prefer that the scope be greater than a dominant business but less than related%lin$ed diversification.
0wners optimum level of diversification is where the * curve turns up! a point between dominant business
and related%constrained diversification.
5anagers prefer a greater scope of diversification than owners. ,s can be seen from the 5 curve in !ig"re
10%&! managers prefer that the firms diversification be between related%lin$ed and unrelated diversification.
4owever! as the curve indicates! there is a point at which managerial employment ris$ increases as the firm
overdiversifies Das discussed in 7hapter #E.
.he optimum level of firm diversification from a managerial ris$ perspective is at point 8 on the 5 curve!
somewhere between related%lin$ed and unrelated businesses.
Aenc" Cos#s an' Go$ernance ,ec(anis0s
.he potential conflict illustrated by !ig"re 10%&! coupled with the fact that principals do not $now which
managers might act opportunistically! demonstrates why principals establish governance mechanisms.
2or firm diversification to approach the shareholder optimum Dpoint , on curve * in !ig"re 10%&E! managerial
autonomy must be controlled by the firms board of directors or by other governance mechanisms that
encourage managers to ma$e strategic decisions that are in the best interests of shareholders.
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!gency costs are the sum of incentive! monitoring! and enforcement costs as well as any residual losses
incurred by principals because it is not possible for principals to guarantee 1AA percent compliance through
monitoring arrangements.
-esearch suggests that more intensive application of governance mechanisms may produce significant changes
in strategies. 7orporate ,merica needs more intense governance in order for continued investment in the stoc$
mar$et to facilitate growth. 4owever! others argue that the indirect costs are even more telling in regard to the
impact on strategy formulation and implementation. .hat is! because of more intense governance! firms may
ma$e decisions that are much less ris$y and thus decrease potential shareholder wealth significantly due to the
implementation of *09.
3
Explain how three internal governance mechanismsownership
concentration! the board of directors! and executive compensation
are used to monitor and control managerial decisions.
OWNERSHIP CONCENTRATION
"wnership concentration is defined both by the number of large%bloc$ owners and by the total percentage of
the firms shares that they own.
#arge$%lock sharehol&ers are investors who typically own at least five percent D" percentE of the firms shares.
'iffuse ownership Da large number of shareholders with small holdings and fewGno large%bloc$ shareholdersE
produces wea$ monitoring of managerial decisions
ma$es it difficult for owners to coordinate their actions effectively
may result in levels of diversification that are beyond the optimum level desired by shareholders Despecially
when this condition is combined with wea$ monitoringE

T(e Growin In&!.ence o& Ins#i#.#iona! Owners
/n recent years! large bloc$ ownership by individuals has declined! but they have been replaced by significant
positions held by institutional owners.
Institutional owners are large bloc$ shareholder positions controlled by financial institutions! such as stoc$
mutual funds and pension funds.
.he importance of institutional owners is indicated by the fact that these shareholders now controls over "A
percent of the stoc$ in large :.*. corporations and approximately "# percent of the stoc$ of the 1!AAA largest
:.*. corporations. .hese ownership percentages suggest that as investors! institutional owners have both the
siFe and the incentive to discipline ineffective top%level managers and can significantly influence a firms
choice of strategies and overall strategic decisions. /nitially! these shareholder activists and institutional
investors concentrated on the performance and accountability of 7E0s and contributed to the ouster of a
number of them. .hey are now targeting what they believe are ineffective boards of directors.
.he rising tide of shareholder pressure also is evidenced by actions ta$en by 7al+E-*.
7al+E-* provides retirement and health coverage to over 1.3 million current and retired public employees.
7al+E-* is generally thought to act aggressively to promote decisions and actions that it believes will
enhance shareholder value in companies in which it invests.
/nstitutions activism may not have a direct effect on firm performance! but its influence may be indirect
through its effects on important strategic decisions.
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Teaching Note: The students should know about a few of the more common anti-takeover
provisions. 4or e!ample, a golden parachute is a type of managerial protection that pays a
guaranteed salary for a specified period of time in the event of a takeover and the loss of
one/s #ob. 1 golden goodbye provides automatic payments to top e!ecutives if their contracts
are not renewed, regardless of the reason for nonrenewal. In the case of ac$uisitions,
managers may receive this compensation even if they voluntarily decide to $uit. &till other
defense strategies are described in greater detail in Table 10.2.
BOARD OF DIRECTORS
Even though institutional ownership has increased! the maCority of firms still =enCoy> the benefits or advantages
of diffuse ownership Di.e.! limited monitoring of managers by individual shareholdersE. 2urthermore! large
financial institution shareholderssuch as ban$sare effectively prevented from having direct ownership of
firms and are prohibited from placing a representative on the boards of directors. .hese conditions highlight the
importance of boards of directors to corporate governance.
Teaching Note: 7egally, the board of directors has broad powers, including:
directing the affairs of the organi)ation
punishing (disciplining) and rewarding (compensating) managers
protecting the rights and interests of shareholders (owners)
8oards are experiencing increasing pressure from shareholders! lawma$ers! and regulators to become more
forceful in their oversight role and thereby forestall inappropriate actions by top executives.
.he %oar& of &irectors is a group of elected individuals whose primary responsibility is to act in the owners
interests by formally monitoring and controlling the corporations top%level executives. /f the board of directors
is appropriately structured and operates effectively! it can protect owners from managerial opportunism.
Table Note: Table 10.1 provides characteristics of three classifications of members of the
board of directors: insiders, related outsiders, and outsiders. These will be useful for students
as you discuss board effectiveness.
(!)#E 10.1
C!assi&ica#ions o& Boar' o& Direc#or ,e01ers
Insiders are represented by the firms 7E0 and other top%level managers.
$elated o"tsiders are individuals who are not involved in the firms day%to%day operations! but may have a
relationship with the company. Examples might include the firms legal counsel! a large customer or supplier!
or a close relative of one of the firms top%level managers.
O"tsiders are individuals who are independent of the firm. .hey are neither involved in the firms day%to%day
operations! nor do they have other relationships with the firm. ,n example of an outsider might be the
president of a university or a community volunteer.
8ecause the primary role of the 'oard of directors is to monitor and ratify maCor managerial actions to protect
the interests of owners! there is a call by advocates of board reform that outsiders should represent a significant
maCority of a boards membership.
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Teaching Note: .utside directors (and boards) are perceived as ineffective because:
insiders dominate the board by limiting the flow of information to outside directors.
outside directors are nominated for board membership by insiders (primarily by the 68.)
and thus are indebted to insiders.
.he drawbac$s of outside boardsK
8ecause outside directors do not have day%to%day contact with the ongoing operations of the firm! they must
obtain detailed! in%depth information about the Huality of management decisions. 'enerally this information
is obtained through freHuent interactions! often developed over time! with inside directors Dgenerally! at
board meetingsE.
/n the absence of rich information! boards may be forced to emphasiFe financial rather than strategic
controls. +otentially! this means that outsider%dominated boardsbecause they lac$ sufficient information
will evaluate managers! not on the basis of the appropriateness of their actions Dwhich the board ratifiedE but
based on the financial outcomes of those actions.
En(ancin #(e E&&ec#i$eness o& #(e Boar' o& Direc#ors
8ecause of the boards importance! the performance of individual board members as well as that of entire
boards is being evaluated more formally and intensely.
5any boards have voluntarily initiated changes! includingK
increasing the diversity of board members bac$grounds
strengthening internal management and accounting control systems
establishing and consistently using formal processes to evaluate the boards performance
the creation of a =lead director> role that has strong powers with regard to the board agenda and oversight of
nonmanagement board member activities
changes in the director compensation! especially reducing or eliminating stoc$ options as part of the pac$age
Teaching Note: The following comments can be used to e!pand the class discussion of
whether a more active board is a more effective board. The findings from research regarding
the effectiveness of board involvement in the strategic decision-making process are mi!ed,
indicating the following:
9oard involvement in the strategic decision-making process may improve firm
performance because it provides the firm/s managers with access to outside opinions, and
outside directors should be more ob#ective and interested in protecting owner interests.
9oards are more likely to be involved in strategic decisions when the firm is smaller and
less diversified, since information regarding strategic actions is more readily available and
both the scope and si)e of the firm are manageable.
9oards are less active in large, diversified firms.
The board/s access to sufficiently rich information on appropriateness of strategic actions
in large diversified firms is limited.
9oard may be limited to evaluating financial outcomes (instead of action appropriateness).
Teaching Note: 5c'insey : 6o. research found that institutional shareholders were willing to
pay an ;; percent premium for the shares of companies when outsiders constitute a ma#ority
of the board, own significant amounts of stock, are not personally tied to top management,
and when management is sub#ected to formal evaluation.
-esearch shows that boards wor$ing collaboratively with managementK
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ma$e higher Huality strategic decisions
ma$e decisions faster
become more involved in the strategic decision%ma$ing process
8ecause of the increased pressure from owners and the potential conflict among board members! procedures are
necessary to help boards function effectively in facilitating the strategic decision%ma$ing process.
/ncreasingly! outside directors are being reHuired to own significant eHuity sta$es as a prereHuisite to holding a
board seat. /n fact! some research suggests that firms perform better if outside directors have such a sta$e.
0ne activist concludes that boards need three foundational characteristics to be effectiveK director stoc$
ownership! executive meetings to discuss important strategic issues! and a serious nominating committee that
truly controls the nomination process to strongly influence the selection of new members.
4
Discuss the types of compensation executives receive and
their effects on strategic decisions.
E5ECUTIVE CO,PENSATION
,s illustrated in the Opening Case and trategic !oc"s! the compensation of top%level managers generates great
interest and strongly held opinions. 0ne reason for this widespread interest can be traced to a natural curiosity
about extremes and excesses. 8ut furthermore! 7E0 pay is an indirect but tangible way to assess governance
processes in large corporations.
E*ecutive compensation is a governance mechanism that see$s to align managers and owners interests
through salary! bonus! and long%term incentive compensation such as stoc$ options.
*ometimes the use of a long%term incentive plan prevents maCor stoc$holders De.g.! institutional investorsE from
pressing for changes in the composition of the board of directors! because they assume that long%term incentives
ensure that top executives will act in shareholders best interests. ,lternatively! stoc$holders largely assume that
top%executive pay and the performance of a firm are more closely aligned when firms have boards that are
dominated by outside members.
:sing executive compensation as a governance mechanism is more challenging in international firms. Evidence
suggests that the interests of owners of multinational corporations may be served best when the firms foreign
subsidiary compensation plans are customiFed to local conditions. .hough uniHue compensation plans reHuire
additional monitoring and increase the firms agency costs! it is important to adCust pay levels to match those of
the region of the world De.g.! higher in the :.*. and lower in ,siaE.
Teaching Note: "hen <aimler9en) ac$uired 6hrysler, it highlighted the fact that top
e!ecutives at 6hrysler made much more than the e!ecutives at <aimler9en)but higher-
paid 6hrysler e!ecutives report to lower-paid <aimler bosses. This e!ample is one that
students seem to be able to grasp.
Developing and implementing an effective incentive compensation program is Huite challenging becauseK
*trategic decisions made by top managers are complex and non%routine. Due to difficulties in Cudging
decision Huality! compensation is often lin$ed to more measurable outcomes such as financial performance.
Decisions made by top%level managers are li$ely to affect firm performance over an extended period of time.
,s a result! it is difficult to assess the effect of current decisions using current period performance.
5any variables Dor outside factorsE intervene between management behavior and firm performance De.g.!
uncontrollable shifts in the environmentE.
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,lthough incentive compensation plans may increase the value of a firm in line with shareholder expectations!
such plans are subCect to managerial manipulation.
,lthough long%term performance%based incentives may reduce temptations to under%invest in the short run! they
increase executive exposure to ris$s associated with uncontrollable eventse.g.! mar$et shifts! industry decline.
STRATEGIC FOCUS
E/ec.#i$e Co0%ensa#ion Is Increasin!" Beco0in a Tare# &or ,e'ia6 Ac#i$is# S(are(o!'ers6 an'
Go$ern0en# Re.!a#ors
,mid growing outrage over excessive executive compensation! a number of outside entities! including the
media! shareholder activists! and government regulators! are see$ing to reduce the increases in 7E0
executive compensation pay pac$ages. .he reason for this outrage can be illustrated by the compensation
pac$age for former 4ome Depot 7E0 -obert 1ardelli. 4ome Depot awarded 5r. 1ardelli M24" million
over his five%year stint. *hareholders felt betrayed that 4ome Depots stoc$ prices dropped 12 percent
during 1ardellis tenure while! during the same period! 4ome Depots most important competitor! 6owes!
increased 1&3 percent.
1ardelli negotiated his compensation pac$age relative to what his compensation would have been had he
stayed with his previous employer D'eneral ElectricE. ,s such! he was awarded M2" million in vested
shares on his start date. ,dditionally! he received a new car every three years Dsimilar price to a 5ercedes%
8enF * seriesE! the opportunity to use the company Cet for personal trips! as well as a M1A million loan at an
annual interest of ".) percent that would be forgiven over five years. .he board of directors that approved
the hiring of 1ardelli was pleased that it could attract and hire such a high%profile candidate.
3ere there other factors that played into the boards decision to approve such a =pricey> pac$ageN , (ew
)or* +i,es article suggested that the six%member compensation board was composed of other 7E0s! one
of whom had an even higher salary than 1ardelli. 0thers were suggested to have had associations with
1ardelli! directly or indirectly! through his previous employer 'E. ,s such! it would be hard for his
associates to lower 1ardellis pay! especially when one board member was ma$ing more than he was.
/ncreased information disclosure as well as the number of scandals associated with bac$dating options have
made board executive compensation committees Dand boards in generalE a focus of activist investors and
increased government scrutiny. 7ertainly 4ome Depot was a target for much of this scrutiny! which forced
the board to oust 1ardelli from his position when he refused to accept a lower pay pac$age.
.he new 4ome Depot 7E0! 2ran$ 8la$e! has a pay pac$age that is significantly less than his predecessor
Daround one%third of 1ardellis annual compensationE. /nterestingly! 8la$e reCected the retailers first offer
because it included too much pay. 4e refused compensation in the form of restricted stoc$ that retains
value even if the share price declines. /n other words! he wanted to ma$e sure that his pay pac$age was in
line with the desires of 4ome Depot shareholders. ,t least in the case of 4ome Depot! it appears that
increased scrutiny! activist shareholder monitoring! and executive pay disclosure rules had a significant
effect in bringing 7E0 pay in line.
"ho really +owns, this problem- (ow much is too much- "hy are shareholders not reacting by
replacing the board members who approve e!ecutive compensation packages deemed
e!cessive- &tudents should be made aware that directors are being held accountable for their
actions through an increasing fre$uency of civil law-suits. 5any companies are furnishing mal-
practice, insurance to directors in order to obtain their services on their boards.
T(e E&&ec#i$eness o& E/ec.#i$e Co0%ensa#ion
1A%1A
.he compensation received by top%level managers! especially by 7E0s! is often a subCect of controversy.
6arge 7E0 compensation pac$ages result mostly from the inclusion of stoc$ options and stoc$ in the total pay
pac$ages. .his is intended to entice executives to $eep the stoc$ price high! thus aligning manager and owner
interests.
-esearch has shown that managers owning more than one percent of the firms stoc$ are less li$ely to be forced
out of their Cobs! even when the firm is performing poorly
2urthermore! a review of the research suggests that over time! firm siFe has accounted for more than "A percent
of the variance in total 7E0 pay! while firm performance has accounted for less than " percent of the variance.
Teaching Note: .ne way that boards have found to compensate e!ecutives is through giving
them loans with favorable, or no, interest for the purpose of buying company stock. If done
correctly, this can be a governance tool, since it aligns e!ecutives/ priorities with those of the
shareholders because the e!ecutives hold stock, not #ust options on the stock. They gain or
lose money along with the shareholders.
/t is important to consider that annual bonuses may provide incentives to pursue short%run obCectives at the
expense of the firms long%term interests.
3hile some stoc$ optionObased compensation plans are well designed with option stri$e prices substantially
higher than current stoc$ prices! too many have been designed simply to give executives more wealth that will
not immediately show up on the balance sheet. -esearch of stoc$ option repricing where the stri$e price value
of the option has been lowered from its original position suggests that action is ta$en more freHuently in high%
ris$ situations. 4owever! it also happens when firm performance was poor to restore the incentive effect for the
option. 0ften! organiFational politics play a role in this.
-epricing stoc$ options does not appear to be a function of management entrenchment or ineffective
governance. .hese firms often have had sudden and negative changes to their growth and profitability. .hey
also freHuently lose their top managers.
/nterestingly! institutional investors prefer compensation schemes that lin$ pay with performance! including the
use of stoc$ options. ,gain! this evidence shows that no internal governance mechanism is perfect.
0ption awards became a means of providing large compensation pac$ages! and the options awarded did not
relate to the firms performance! particularly when boards showed a propensity to reprice options at a lower
stri$e price when stoc$ prices fell precipitously. 0ption awards are becoming increasingly controversial.
Teaching Note: 9oard directors also receive compensation. &ome recent figures follow:
5edian base compensation for directors in telecommunications was almost =>?,???.
<irectors at 5icrosystem Inc. received average compensation of about =@;?,??? a year,
while directors at 6ompa$ earned over =AB?,??? and directors at Cfi)er received almost
=DB?,???.
.n average, directors at the largest D?? firms received about =;A@,???.
&imilar to e!ecutives in the firm, there is a move by large institutional investors such as
6alC8E& to pay directors at least partially in stock (some estimating that some F? percent
of director pay will be in company stock).
7
Describe how the external corporate governance mechanism
the mar$et for corporate controlacts as a restraint on top%
1A%11
level managers strategic decisions.
,ARKET FOR CORPORATE CONTROL
.he mar$et for corporate control generally comes into use as an external governance mechanism only after
internal governance mechanisms have failed.
! )rief +istory of the ,arket for Corporate Control
.he mar$et for corporate control has been active for some time. .he 1L)As were $nown as a time of
merger mania! with around ""!AAA acHuisitions valued at approximately M1.3 trillion. 4owever! there
were many more acHuisitions in the 1LLAs! and the value of mergers and acHuisitions in that decade was
more than M1A trillion. .he maCor reduction in the stoc$ mar$et resulted in a significant drop in
acHuisition activity in the first part of the twenty%first century. 4owever! the number of merger and
acHuisitions began to increase in 2AA3! and the mar$et for corporate control has become increasingly
international with over 4A percent of the merger and acHuisition activity involving two firms from
different countries.
3hile some acHuisition attempts are intended to obtain resources important to the acHuiring firm! most of
the hostile ta$eover attempts are due to the target firms poor performance. .herefore! target firm
managers and members of the boards of directors are highly sensitive about hostile ta$eover bids. /t often
means that they have not done an effective Cob in managing the company because of the performance
level inviting the bid. /f they accept the offer! they are li$ely to lose their CobsP the acHuiring firm will
insert its own management. /f they reCect the offer and fend off the ta$eover attempt! they must improve
the performance of the firm or ris$ losing their Cobs as well.
.he market for corporate control is composed of individuals and firms who buy ownership positions in Dor ta$e
overE potentially undervalued firms. .hey do this in order to form a new division in an established diversified
firm! merge two previously separate firms! and usually replace the target firms management team to revamp
the strategy that caused low firm performance.
.he mar$et for corporate control governance mechanism should be triggered by a firms poor performance
relative to industry competitors. , firms poor performance! often demonstrated by the firms earning below%
average returns! is an indicator that internal governance mechanisms have failedP that is! their use did not result
in managerial decisions that maximiFed shareholder value.
,anaeria! De&ense Tac#ics
8ecause of the threat of dismissal! managers have devised a number of defensive tactics designed to both ward
off ta$eovers and buffer or protect managers from external governance mechanisms. .hese tactics includeK
managerial pay interventions! such as golden parachutes
asset restructuring! such as divesting a business unit or division
financial restructuringe.g.! stoc$ repurchases! paying out a firms free cash flows as a dividend
changing the state of incorporation
ma$ing targeted shareholder repurchases D$nown as greenmailE
(!)#E 10.
+ostile (akeover 'efense -trategies
1A%12
.his table presents a number of defense strategies and identifies them according to category Dpreventive!
reactiveE! popularity Dhigh! medium! low! very lowE! effectiveness Dhigh! medium! low! very lowE! and
stoc$holder wealth effects Dpositive! negative! inconclusiveE. .he defense strategies mentioned are poison pill!
corporate charter amendment! golden parachute! litigation! greenmail! standstill agreement! and capital structure
change.

5ost institutional investors oppose the use of defense tactics. 2or example! ./,,%7-E2 and 7al+E-* have
ta$en actions to have several firms poison pills eliminated.
.he mar$et for corporate control also can be plagued by inefficiency. /n the 1L)As! roughly "A percent of all
ta$eovers targeted firms that were high performers. ,s a result!
acHuisition prices were excessive
expensive defensive strategies were often implemented to protect the firm
Despite its inefficiency! the threat of acHuisition by corporate raiders can serve as an effective constraint on the
managerial growth motive and result in strategies that are in the best interests of the firms owners.
Teaching Note: 1s mentioned throughout the chapter, internal and e!ternal governance
mechanisms, while they may restrain managerial actions, are imperfect means of controlling
managerial opportunism. This means that some combination of both internal and e!ternal
mechanisms is necessary.
8
Discuss the use of corporate governance in international
settings! in particular in 'ermany and (apan.
INTERNATIONAL CORPORATE GOVERNANCE
0ur discussion of internal and external governance mechanismsand their effectiveness in controlling
managerial behaviorhas been centered on the :.*. and the :.<. 8ut this does not necessarily apply to the
systems of corporate governance used elsewhere in the world O e.g.! 'erman and (apanese firms.
3hile the stability that has been associated with the 'erman and (apanese systems has been perceived as a
strength! it is possible! given the dynamic and uncertain nature of the new competitive landscape! that stability
may be a potential source of wea$ness.
Cor%ora#e Go$ernance in Ger0an"
.he owner%manager relationship in 'ermany differs from that described for the :.*. 2or exampleK
/n many private 'erman firms! the owner and manager are the same person.
/n publicly traded firms there often is a dominant shareholder.
8an$s historically have occupied a central position in 'erman governance structure.
8an$s became maCor shareholders when companies that they financed either sought new capital in the stoc$
mar$et or defaulted on loans.
8an$s generally hold less than 1A percent of a firms stoc$.
8an$ ownership of a single firms stoc$ is limited to 1" percent of the ban$s capital.
.hree large ban$sDeutsche! Dresdner! and 7ommerFban$hold maCority positions in large 'erman firms
through their own holdings and proxy votes for shareholders who retain shares with the ban$s.
1A%13
'erman firms with more than 2!AAA employees must have a two%tiered board structure! with supervision of
management being separated from other board duties and all of the functions of direction and management
being placed in the hands of the -orstand or management board.
,ppointment to the management board is the responsibility of the A"fsichtsrat or supervisory board.
Despite the ability of maCor owners and ban$s to monitor and control the managers of large 'erman firms!
maximiFing shareholder value has not been an historical focus. 4owever! this is changing.
Teaching Note: 1 shift is taking place in *erman firms/ historic lack of focus on ma!imi)ing
shareholder value. 4or e!ample, &*7 6arbon 1* lost more than =G; million in the early
;>>?s and was later restructured to turn the corporation around. In particular the firm/s
governance structure was changed, transparent accounting practices were adopted, and the
firm set a goal of enhancing shareholder value. The firm/s performance has since improved,
and many attribute this to the new governance structure.
Cor%ora#e Go$ernance in Ja%an
7orporate governance in (apan is affected by the concepts of obligation! family! and consensus.
/n (apan! o'ligation goes beyond principles but is more a product of specific causes! events! and relationships.
/t can mean returning a service for one that has been rendered.
.he concept of fa,ily goes beyond the ,merican concept to include the firmindividuals see themselves as
members of a company family. ,nd the family concept is extended to include members of the firms *eirets"! a
group of firms that are tied together by cross%shareholdings! interrelationships! and interdependencies.
Consens"s represents one of the most important influences on governance structure in (apan. .his reHuires that
managersamong othersexpend significant amounts of energy to win the hearts and minds of people rather
than proceed by the edicts of top%level managers.
,s in 'ermany! ban$s also play an important role in financing and monitoring large public firms in (apan.
.he ban$ owning the largest share of stoc$s and the largest amount of debtthe main ban$has the closest
relationship with the companys top executives.
8an$s occupy an important position in the governance system! both financing and monitoring firms.
.he main ban$the ban$ holding the largest share of a firms debtprovides financial advice and assumes
primary responsibility for monitoring the firms management.
(apanese ban$s can hold up to five percent of a firms stoc$.
'roups of ban$s can hold up to 4A percent of a firms stoc$.
/n many cases! ban$ relations are an integral part of the (apanese firms keiretsu Dan industrial group of
firms that interact with the same ban$E.
Teaching Note: Keiretsus are both diversified and vertically integrated to the e!tent that they
generally include one or more firms in almost all important industrial sectors.
,s in 'ermany! (apans corporate governance structure is changing. 2or example! the role of ban$s in the
monitoring and control of managerial behavior and firm outcomes has become less significant.

STRATEGIC FOCUS
1A%14
S(are(o!'er Ac#i$is#s In$a'e Ja%an9s Lare Fir0s Tra'i#iona!!" Foc.se' on :S#a2e(o!'er;
Ca%i#a!is0
(apan has traditionally applied relationship%capitalism! which is based on the premise that firms help each
other when they are wea$ and facilitate and encourage each other as they become strong. .his system has
been a very effective method of protection in order to $eep (apanese firms (apanese. .his relationship%
capitalism created a system for protection against =outside> owners by having a close%$nit group of insiders
who manage the firm as well as a larger set of interloc$ing shareholders who are mutually bonded by
owning each others stoc$. /n the 1L)As! these cross%shareholdings accounted for "A percent of the eHuity
in (apanese firms. -ecently! relationship%capitalism accounts for only 2A percent of total eHuity.
2oreign ownership of (apanese firms has increased from approximately 4.& percent in 1LLA to 2) percent in
2AA&. , parallel trend is the increase in activist foreign shareholders ma$ing proposals in governing the
firms differently. (apanese managers are facing an increasing level of activism! especially by foreign
shareholders. /nterestingly! in (apan! shareholders can vote directly on dividends and executive pay. .hus!
on the surface it would appear that (apanese stoc$ mar$et policies are more shareholder%friendly than those
in the :nited *tates or the :nited <ingdom. 2urthermore! shareholders can vote to dismiss the entire board
without cause. 4owever! (apanese investors do not ta$e up this power readily and most often defer to
executive proposals. *ince 2) percent of (apanese shares are now held by foreign institutional investors!
these practices have begun to change. *hareholder activity is becoming more common. /n (une 2AA&!
firms holding their shareholders meetings faced 3A shareholder resolutions which were twice as many as
there were one year earlier. (apanese managers who are determined to maintain a tightly%$nit business
culture feel threatened. *ome of the issues raised by shareholders included the accumulation of heavy cash
reserves that could be used to pay dividends that are inline with those paid by :.*. and :.<. firms and
reorganiFations that would result in employee layoffs.
(apanese managers have fought bac$ through use of the (apanese media to paint non%(apanese shareholders
as short%sighted financial criminals. /n fact! the long%term health of (apanese firms might be improved
given that (apanese firms hold cash and securities eHuivalent to 1# percent of 'D+! whereas ,merican
firms long%term average of cash and securities is about " percent. ,lthough these slac$ resources in (apan
may facilitate a longer%term view! from the eyes of the (apanese firms have recently begun experiencing
activist shareholders who see$ to increase returns through improved dividend policy.
"ere not the symptoms of change anticipated in this case- This is a clash of cultures. Hapanese
business culture has valued relationships and consensus which calls for the expenditure of
significant amounts of energy to win the hearts and minds of people whenever
possible, as opposed to top executives issuing edicts. Consensus is highly valued,
even when it results in a slow and cumbersome decision-making process. Do
students feel that compromise is a realistic strategy in addressing this apparent
conundrum

G!o1a! Cor%ora#e Go$ernance
,s discussed in this section! the changes in governance that are ta$ing place in 'ermany and (apan are
representative of the twenty%first century competitive landscape! where customer demands are becoming more
similar and shareholder value is becoming a more significant focus of managerial agents. .his will result in
more uniform governance structures.
Teaching Note: 8!amples of differences and changes in international governance follow:
In 4rance, anger has been growing over the lack of information on top e!ecutive
compensation. 1 recent report recommended that the positions of 68. and chairman of
1A%1"
the board be held by two different individuals. It also recommended reducing the tenure of
board members and to disclose their pay.
In &outh 'orea, principles of corporate governance are being adopted to provide proper
board and management incentives to pursue the interests of both the company and the
shareholders and to facilitate effective monitoring.
6hanges in corporate governance are occurring even in transitional economies, such as
6hina and Eussia, though implemented more gradually. The use of stock-based
compensation plans has influenced foreign companies to invest (particularly in 6hina).
<
Describe how corporate governance can foster ethical
strategic decisions and the importance of such behaviors on
the part of top%level executives.
GOVERNANCE ,ECHANIS,S AND ETHICAL BEHAVIOR
'overnance mechanisms discussed in this chapter are focused on ensuring that managers wor$ effectively
toward meeting their obligation to maximiFe shareholder wealth. 4owever! shareholders are only one group of
the firms sta$eholders Das discussed in 7hapter 1E.
0ver the long%term! the demands of other $ey sta$eholderssuch as employees! customers! suppliers! and the
communityalso must be satisfied in order to maximiFe shareholder wealth.
2or that reason! and others! governance mechanisms must be carefully designed and implemented so that
managers attention is not focused on maximiFing short%term returns and to ensure that they consider the
interests of all sta$eholders.
Teaching Note: Hohn &males (outside director of the board at *5) has commented that the
most fundamental obligation of management is to perpetuate the organi)ation, taking priority
even over stockholder interests. (is comments may provide a good opportunity to engage
students in a discussion about the purpose of the firm and its obligations to all stakeholders.
= ANSWERS TO REVIEW >UESTIONS
*? W(a# is cor%ora#e o$ernance) W(a# &ac#ors acco.n# &or #(e consi'era1!e a0o.n# o& a##en#ion
cor%ora#e o$ernance recei$es &ro0 se$era! %ar#ies6 inc!.'in s(are(o!'er ac#i$is#s6 1.siness %ress
wri#ers6 an' aca'e0ic sc(o!ars) W(" is o$ernance necessar" #o con#ro! 0anaers9 'ecisions) @%%? +87A
+8<B
7orporate governance is a relationship among sta$eholders that is used to determine and control the direction
and performance of organiFations.
7orporate governance receives a great deal of attention because governance mechanisms sometimes fail to
adeHuately monitor and control top%level managers strategic decisions. /f the behavior of top%level mangers is
not monitored and controlled effectively! this could mean that the firm will not be strategically competitive.
Effective corporate governance is also of interest to nations. , country prospers as its firms grow and provide
employment! wealth! and satisfactionthus improving standards of living. .hese aspirations are met when
firms are competitive internationally in a sustained way. 7orporate governance reflects the standards of the
company! which collectively reflect societal standards. .hus! in many corporations! shareholders attempt to
hold top%level managers more accountable for their decisions and the results they generate. ,s with individual
1A%1#
firms and their boards! nations that govern their corporations effectively may gain a competitive advantage over
rival countries.
,s owners delegate strategy development and decision ma$ing to managers! conflicts of interest emerge
managers may select strategic alternatives that serve their own best interests! not those of the owners.
'overnance mechanisms help owners DshareholdersE to ensure that managers ma$e strategic decision that are in
the best interests of the former. /f internal governance mechanisms are ineffective! the mar$et for corporate
control Dan external governance mechanismE may be activated.
+? W(a# 'oes i# 0ean #o sa" #(a# owners(i% is se%ara#e' &ro0 0anaeria! con#ro! in #(e 0o'ern
cor%ora#ion) W(" 'oes #(is se%ara#ion e/is#) @%? +8<B
4istorically! :.*. firms were managed by the foundersGowners and their descendants. /n these cases! corporate
ownership and control resided in the same personDsE. ,s firms grew larger! ownership and control were
separated in most large corporations so that control of the firm shifted to professional managers while
ownership was dispersed among unorganiFed stoc$holders who were removed from day%to%day management.
.hese changes created the modern public corporation! which is based on the efficient separation of ownership
and managerial control. *upporting the separation is a basic legal premise suggesting that the primary obCective
of a firms activities is to increase the corporations profit and thereby the financial gains of the owners Dor
shareholdersE. 4owever! this right also reHuires that they accept the financial ris$ of the firm and its operation.
,s shareholders diversify their investments over a number of corporations! their ris$ declines Dthe poor
performance or failure of any one firm in which they invest has less overall effectE. *hareholders thus
specialiFe in managing their investment ris$ while managers focus on decision ma$ing. 3ithout management
specialiFation in decision ma$ing and owner specialiFation in ris$ bearing! a firm probably would be limited by
the abilities of its owners to manage and ma$e effective strategic decisions. .herefore! in concept! the
separation and specialiFation of ownership Dris$ bearingE and managerial control Ddecision ma$ingE should
produce the highest returns.
-? W(a# is an aenc" re!a#ions(i%) W(a# is 0anaeria! o%%or#.nis0) W(a# ass.0%#ions 'o owners o&
0o'ern cor%ora#ions 0a2e a1o.# 0anaers as aen#s) @%%? +8CA+<+B
Despite its advantages! the separation of ownership and control may result in some potential costs Dand ris$sE
for owners by creating an agency relationship. ,n agency relationship exists when one or more persons Dthe
principal or principalsE hires another person or persons Dthe agent or agentsE as a decision%ma$ing specialist to
perform a service. /n other words! the agency relationship exists when one party delegates decision ma$ing to
another party in return for compensation.
.he owner%agent relationship enables the possibility of ,anagerial opport"nis,! the see$ing of self%interest
with guile Di.e.! cunning or deceitE where opportunism is represented by an inclination toward self%see$ing
behaviors. 4owever! before observing the results of decisions! it is impossible to $now which agents will
behave opportunistically and which ones will not. , managers reputation is an imperfect guide to future
behavior and opportunistic behavior cannot be observed until after it has occurred.
3? How is eac( o& #(e #(ree in#erna! o$ernance 0ec(anis0sowners(i% concen#ra#ion6 1oar's o&
'irec#ors6 an' e/ec.#i$e co0%ensa#ion=.se' #o a!in #(e in#eres#s o& 0anaeria! aen#s wi#( #(ose o& #(e
&ir09s owners) @%%? +<-A+CDB
Ownership concentration is an effective governance mechanism because owners of large bloc$s of stoc$
Drepresenting a higher percentage of ownershipE have a greater financial interest in monitoring managerial
decisions than do small shareholders DcharacteriFed as diffuse ownershipE. /ncreasingly! instit"tional investors
such as stoc$ mutual funds and public%pension funds hold large bloc$s of stoc$! and these shareholders
aggressively monitor and ta$e action against managers who receive excessive compensation and per$s but
achieve only poor firm performance.
1A%1&
5onitoring and controlling managerial decisions are supposed to be accomplished through the firms 'oard of
directors! members of which are elected by shareholders to oversee managers and ensure that the firm is
operated in the best interests of owners. 5embers can be classified into three categoriesinsiders Dthe 7E0
and other top%level managersE! related outsiders Dmember who are not involved in day%to%day operations but
have some relationship with the firmE! and outsiders Dmembers who are independent from the firm and its
operationsE.
E.ec"tive co,pensation can be used to help align the interests of managers and owners by tying managerial pay
to firm performance through salaries! bonuses! and long%term incentives based on stoc$ options. 4owever!
given the complexity and long%term nature of strategic decisions! it may be difficult to perfectly align
compensation with firm performance. 2irst! the strategic decisions made by top%level managers are typically
complex and nonroutine! so direct supervision of executives is inappropriate for Cudging the Huality of their
decisions. .hus! compensation of top%level managers is usually determined by the firms financial
performance. *econd! the impact of an executives decisions is not immediate! ma$ing it difficult to assess the
effect of decisions on the corporations performance. .hird! a number of variables Dunpredictable economic!
social! or legal changesE intervene between top%level managerial behavior and firm performance! ma$ing it
difficult to discern the effects of strategic decisions.
4? W(a# #ren's e/is# rear'in e/ec.#i$e co0%ensa#ion) W(a# is #(e e&&ec# o& #(e increase' .se o& !onA
#er0 incen#i$es on e/ec.#i$es9 s#ra#eic 'ecisions) @%%? +<8A+CDB
/n recent times! many sta$eholders! including shareholders! have been angered by what they consider the
excessive compensation received by some top%level managers! especially 7E0s. .he primary reason for such
large compensation pac$ages is the inclusion of stoc$ options and stoc$ in the total pay pac$ages. .he primary
reasons for compensating executives with stoc$ is that it provides incentives to $eep the stoc$ price high! thus
aligning manager and owner interests. 4owever! there may be some unintended conseHuences. -esearch has
shown that managers who own more than one percent of the firms stoc$ are less li$ely to be forced out of their
Cobs! even when the firm is performing poorly.
/ncreasingly! long%term incentive plans are becoming a critical part of compensation pac$ages in :.*. firms.
.he use of longer%term pay helps firms cope with or avoid potential agency problems. 8ecause of this! the stoc$
mar$et generally reacts positively to the introduction of a long%range incentive plan for top executives.
3hile some stoc$ option%based compensation plans are well designed with option stri$e prices substantially
higher than current stoc$ prices! too many have been designed simply to give executives more wealth that will
not immediately show up on the balance sheet. -esearch of stoc$ option repricing where the stri$e price value
of the option has been changed to be lower than it was originally set suggests that step is ta$en more freHuently
in high%ris$ situations. 4owever! it also happens when firm performance was poor to restore the incentive effect
for the option. 8ut evidence also suggests that organiFational politics are often involved. ,dditionally! research
has found that repricing stoc$ options does not appear to be a function of management entrenchment or
ineffective governanceP these firms often have had sudden and negative changes to their growth and
profitability. .hey also freHuently lose their top managers. /nterestingly! institutional investors prefer
compensation schemes that lin$ pay with performance! including the use of stoc$ options. ,gain! this evidence
shows that no internal governance mechanism is perfect.
3hile stoc$ options became highly popular as a means of compensating top executives and lin$ing pay to
performance! they also have become controversial of late. /t seems that option awards became a means of
providing large compensation pac$ages and the options awarded did not relate to the firms performance!
particularly when boards showed a propensity to reprice options at a lower stri$e price when stoc$ prices fell
precipitously. 8ecause of the large number of options granted in recent years and the increasingly common
practice of repricing them! some have called for expensing the options by the firm at the time they are awarded.
.his action could be Huite costly to many firms stated profits. .hus! some firms have begun to move away
from granting stoc$ options.
1A%1)
7? W(a# is #(e 0ar2e# &or cor%ora#e con#ro!) W(a# con'i#ions enera!!" ca.se #(is e/#erna! o$ernance
0ec(anis0 #o 1eco0e ac#i$e) How 'oes #(e 0ec(anis0 cons#rain #o% e/ec.#i$es9 'ecisions an' ac#ions)
@%%? +CDA+C+B
.he mar$et for corporate control is an external governance mechanism that becomes active when a firms
internal controls fail. .he ,ar*et for corporate control is composed of individuals and firms that buy
ownership positions in Dor ta$e overE potentially undervalued corporations so they can form new divisions in
established diversified companies or merge two previously separate firms. 8ecause they are assumed to be the
party responsible for formulating and implementing the strategy that led to poor performance! the top
management team of the acHuired company is usually replaced. .hus! the mar$et for corporate control
disciplines managers that are ineffective or act opportunistically. , firms poor performance is an indication
that internal governance mechanisms have failed Dthat is! their use did not result in managerial decisions that
maximiFed shareholder valueE! opening the door to the involvement of the mar$et for corporate control. /ndeed!
hostile ta$eovers are the maCor activity in the mar$et for corporate control.
8? W(a# is #(e na#.re o& cor%ora#e o$ernance in Ger0an" an' Ja%an) @%%? +C3A+C4B
/n many private 'erman firms! owner and manager may be the same individual and thus no agency problem
will exist. Even in publicly traded corporations! there is often a dominant shareholder! so the problem is
minimiFed. .hus! ownership concentration is an important means of corporate governance in 'ermany! Cust as
it is in the :.*.
4istorically! ban$s have been at the center of the 'erman corporate governance structure! which is the case in
many continental European countries such as /taly and 2rance. ,s lenders! ban$s become maCor shareholders
when companies they had financed earlier see$ funding on the stoc$ mar$et or default on loans. ,lthough
sta$es are usually under 1A percent! there is no legal limit on how much of a firms stoc$ ban$s can hold Dexcept
that a single ownership position cannot exceed 1" percent of the ban$s capitalE. *hareholders can tell the
ban$s how to vote their ownership position! but they generally elect not to do so. 8an$s monitor and control
managers both as lenders and as shareholders by electing representatives to supervisory boards.
'erman firms with more than 2!AAA employees are reHuired to have a two%tier board structure. .hrough this
structure! the supervision of management is separated from other duties normally assigned to a board of
directors! especially the nomination of new board members. .hus! 'ermanys two%tiered system places the
responsibility to monitor and control managerial Dor supervisoryE decisions and actions in the hands of a
separate group. 3hile all the functions of direction and management are the responsibility of the management
board! appointment to this body is the responsibility of the supervisory tier. Employees! union members! and
shareholders appoint members to the latter.
4istorically! 'erman executives have not been dedicated to the maximiFation of shareholder value. 4owever!
corporate governance in 'ermany is changing. Due at least partially to the increasing globaliFation of business!
many governance systems are beginning to gravitate toward the :.*. system.
,ttitudes toward corporate governance in (apan are affected by the concepts of obligation! family! and
consensus. ,s part of a corporate family! individuals are members of a unit that envelops their liveseven the
$eiretsu is a family! and certainly more than an economic concept. 7onsensus! an important influence in
(apanese corporate governance! calls for the expenditure of significant amounts of energy to win the hearts and
minds of people whenever possible! as opposed to depending on edicts from top executives. 7onsensus is
highly valued! even when it results in a slow and cumbersome decision%ma$ing process.
,s in 'ermany! ban$s play an important role in financing and monitoring large public firms in (apan. .he ban$
owning the largest share of stoc$s and the largest amount of debt Dthe main ban$E has the closest relationship
with the companys top executives. .he main ban$ provides financial advice to the firm and also closely
monitors managers. .hus! (apan has a ban$%based financial and corporate governance structure compared to
the :nited *tates mar$et%based financial and governance structure.
1A%1L
,side from lending money DdebtE! a (apanese ban$ can hold up to five percent of a firms total stoc$P a group of
related financial institutions can hold up to 4A percent. /n many cases! main%ban$ relationships are part of a
horiFontal $eiretsu Da group of firms tied together by cross%shareholdingsE. , $eiretsu firm usually owns less
than 2 percent of any other member firmP however! each company typically has a sta$e of that siFe in every firm
in the $eiretsu. ,s a result! somewhere between 3A percent and LA percent of a typical firm is owned by other
members of the $eiretsu. .hus! a $eiretsu is a system of relationship investments.
,s is the case in 'ermany! (apans corporate governance structure is changing. 2or example! because of their
continuing development as economic organiFations! the role of ban$s in the monitoring and control of
managerial behavior and firm outcomes is less significant than it has been. .he ,sian economic crisis in the
later part of the 1LLAs substantially harmed (apanese firms! ma$ing transparent the governance problems in the
system.
<? How can cor%ora#e o$ernance &os#er e#(ica! s#ra#eic 'ecisions an' 1e(a$iors on #(e %ar# o&
0anaers as aen#s) @%%? +C<A+CCB
/n the :nited *tates! the focus of governance mechanisms is on the control of managerial decisions to ensure
that shareholders interests will be served! but product mar$et sta$eholders De.g.! customers! suppliers! and host
communitiesE and organiFational sta$eholders De.g.! managerial and nonmanagerial employeesE are important as
well. .herefore! at least the minimal interests or needs of all sta$eholders must be satisfied by outcomes from
the firms actions. 0therwise! dissatisfied sta$eholders will decide to withdraw their support to one firm and
provide it to another De.g.! customers will purchase products from a supplier offering an acceptable substituteE.
= E5PERIENTIAL E5ERCISES
E/ercise *E In#erna#iona! Go$ernance Co'es
,s described in the chapter! passage of the *arbanes%0xley ,ct in 2AA2 has drawn attention to the
importance of corporate governance. *imilar legislation is pending in other nations as well. 4owever!
interest in improved governance predated *09 by a decade in the form of governance codes or guidelines.
.hese codes established sets of =best practices> for both board composition and processes. .he first such
code was developed by the 7adbury 7ommittee for the 6ondon *toc$ Exchange in 1LL2. .he ,ustralian
*toc$ Exchange developed its guidelines in the 4ilmer -eport! released in 1LL3. .he .oronto *toc$
Exchange developed its guidelines the following year in the Dey -eport. .oday! most maCor stoc$
exchanges have governance codes.
3or$ing in small groups! find the governance codes of two stoc$ exchanges. +repare a short Dtwo to three
pages! single%spacedE bullet point comparison of the similarities and differences between the two codes. 8e
sure to include the following topics in your analysisK
4ow are the guidelines structuredN Do they consist of rules Di.e.! reHuiredE or recommendations
Di.e.! suggestionsEN 3hat mechanism is included to monitor or enforce the guidelinesN
3hat board roles are addressed in the guidelinesN 2or example! some codes may place most or all
of their emphasis on functions derived from the importance of the agency relationship illustrated
in 2igure 1A.1! such as monitoring! oversight! and reporting. 7odes might also mention the boards
role in supporting strategy! or their contribution to firm performance and shareholder wealth.
3hat aspects of board composition and structure are covered in the guidelinesN 2or instance! items
included in different codes include the balance of insiders and outsiders! committees! whether the
7E0 also serves as board chair! director education andGor evaluation! compensation of officers and
directors! and ownership by board members.
E/ercise +E Go$ernance an' Persona! In$es#0en#s
1A%2A
'overnance mechanisms are considered to be effective if they meet the needs of all sta$eholders! including
shareholders. ,s an investor! how much weight! if at all! do you place on a firms corporate governanceN /f
you currently own any stoc$s! select a firm that you have invested in. /f you do not own any stoc$s! select a
publicly traded company that you consider an attractive potential investment. 3or$ing individually!
complete the following research on your target firmK
2ind a copy of the companys most recent proxy statement. +roxy statements are mailed to
shareholders prior to each years annual meeting and contain detailed information about the
companys governance and presents issues on which a shareholder vote might be held. +roxy
statements are typically available from a firms 3eb site Dloo$ for an =/nvestors> submenuE. ?ou
can also access proxy statements and other government filings such as the 1A%< from the *E7s
ED',- database DhttpKGGwww.sec.govGedgar.shtmlE.
7onduct a search for news articles that address the governance of your target company. :sing
different $eywords De.g.! governance! directors! or 'oard of directorsE in combination with the
company name may be helpful.
*ome of the topics that you should examine includeK
7ompensation plans Dfor both the 7E0 and board membersE
8oard composition De.g.! board siFe! insiders and outsidersE
7ommittees
*toc$ ownership by officers and directors
3hether the 7E0 holds both 7E0 and board chairperson positions
/s there a lead director who is not an officer of the companyN
8oard seats held by bloc$holders or institutional investors
,ctivities by activist shareholders regarding corporate governance issues of concern
+repare a one page! single%spaced memo summariFing the results of your findings. ?our memo should
include the following topicsK
*ummariFe what you consider to be the $ey aspects of the firms governance mechanisms.
8ased on your review of the firms governance! did you change your opinion of the firms
desirability as an investmentN 3hy or why notN
=
INSTRUCTORFS NOTES FOR
E5PERIENTIAL E5ERCISES
E/ercise *E In#erna#iona! Go$ernance Co'es
.he goals of this exercise are two%foldK first! the exercise helps to illustrate the stoc$ exchanges use codes
of best practice as an alternative to regulation De.g.! *09E. /f the exercise is discussed in class! it can be
helpful to as$ students their opinions of the relative merits of self%policing via exchange reHuirements
versus government intervention. , second goal of the exercise is to highlight the global aspect of corporate
governance.
1A%21
.he European 7orporate 'overnance /nstitute maintains a list of governance codes for a number of
countries! including nations outside the E:. .heir database includes historical listings! so that both the
most recent and older codes are often available for a given region. 2or example! the ,ustralia section
includes both the current ,ustralian *toc$ Exchange D,*9E guidelines! as well as the 8osch -eport from
1LL". /f the instructor is loo$ing for a more advanced proCect on this topic! students could be reHuired to
compare the evolution of governance codes over time for a particular region. .he E7'/ website isK
httpKGGwww.ecgi.org
,dditionally! the 7orporate 'overnance 1etwor$ is a useful resource for other materials relating to
governance issuesK
httpKGGwww.corpgov.net
.he following practitioner articles may also be helpful for framing a discussion of Qgood governance
guidelinesK
2in$elstein! *.! R 5ooney! ,.7. 2AA3. 1ot the usual suspectsK 4ow to use board process to ma$e boards
better. .he ,cademy of 5anagement Executive. 5ay 2AA3. ;ol. 1&! /ss. 2P p. 1A1
1orburn! D.! 8oyd! 8.<.! 2ox! 5.! R 5uth! 5. 2AAA. /nternational corporate governance reform.
European 8usiness (ournal. ;ol. 12! /ssue 3! p. 11#%133.
E/ercise +E Go$ernance an' Persona! In$es#0en#s
2or this exercise! students are as$ed to evaluate the governance of a firm they currently invest in! or a firm
they might consider investing in. .he main purpose of the exercise is to help ma$e a connection between
different governance elements De.g.! board composition! eHuity holdings by directors! executive
compensationE and a firms financial performance. *tudents are as$ed to prepare a single page memo that
answers the following HuestionsK
*ummariFe what you consider to be the $ey aspects of the firms governance mechanisms.
8ased on your review of the firms governance! did you change your opinion of the firms
desirability as an investmentN 3hy! or why notN
, secondary goal of the exercise is to familiariFe students with proxy statements as a resource for analyFing
corporate governance. , related benefit is the use of the *ecurities and Exchange 7ommission ED',-
database DhttpKGGwww.sec.govGedgar.shtmlE.
8ecause this exercise is completed individually! it can be helpful to spend some time in class debriefing the
assignment. ,n easy way to do this is to restate the Huestion =8ased on your review of the firms
governance! did you change your opinion of the firms desirability as an investmentN> ,s$ for a show of
hands for those that did change their opinion! and those that did not. *tarting with the former group! as$K
3hat prompted the change in opinionN
3ere there both positive and negative opinion changesN
4ow strong was the change O relatively minor! moderate! or substantialN
1ext! follow up with the =no change> group! and as$ several students for the basis for their assessment.
1A%22
2inally! as$ students how much weight they will play on corporate governance when considering future
investments.
= ADDITIONAL >UESTIONS AND E5ERCISES
.he following Huestions and exercises can be presented for in%class discussion or assigned as homewor$.
A%%!ica#ion Disc.ssion >.es#ions
1. .he roles and responsibilities of top executives and members of a corporations board of directors are
different. .raditionally! executives have been responsible for determining the firms strategic direction and
implementing strategies to achieve it! whereas the board of directors has been responsible for monitoring
and controlling managerial decisions and actions. *ome argue that boards should become more involved
with the formulation of a firms strategies. 4ow would the boards increased involvement in the selection
of strategies affect a firms strategic competitivenessN 3hat evidence can the students offer to support their
positionN
2. ,s$ the students if they believe that large :.*. firms have been overgoverned by some corporate
governance mechanisms and undergoverned by othersP provide an example of each.
3. 4ow can corporate governance mechanisms create conditions that allow top executives to develop a
competitive advantage and focus on long%term performanceN 4ave the students use the /nternet to search
the business press and give an example of a firm in which this occurred.
4. *ome believe that the mar$et for corporate control is not an effective governance mechanism. 3hat factors
might account for the ineffectiveness of this method of monitoring and controlling managerial decisionsN
". +resent the following comment to the classK =,s a top executive! the only agency relationship / am
concerned about is the one between myself and the firms owners. / thin$ that it would be a waste of my
time and energy to worry about any other agency relationships.> 3hat are these other agency relationshipsN
4ow would the students respond to this personN Do they accept or reCect this viewN 4ave them support
their position.
E#(ics >.es#ions
1. ,s explained in this chapter! using corporate governance mechanisms should establish order between
parties whose interests may be in conflict. Do owners of a firm have any ethical responsibilities to
managers in a firm that uses governance mechanisms to establish orderN /f so! what are those
responsibilitiesN
2. /s it ethical for a firms owner to assume that agents Dmanagers hired to ma$e decisions in the owners best
interestsE are averse to ris$N 3hy or why notN
3. 3hat are the responsibilities of the board of directors to sta$eholders other than shareholdersN
4. 3hat ethical issues surround executive compensationN 4ow can we determine whether top executives are
paid too muchN
". /s it ethical for firms involved in the mar$et for corporate control to target companies performing at levels
exceeding the industry averageN 3hy or why notN
#. 3hat ethical issues! if any! do top executives face when as$ing their firm to provide them with a golden
parachuteN
&. 4ow can governance mechanisms be designed to ensure against managerial opportunism! ineffectiveness!
and unethical behaviorsN
In#erne# E/ercise
.he use of the /nternet for buying and selling stoc$s has opened up mar$ets to an unprecedented number of
people. 3ith the clic$ of a mouse! one can buy shares of the hottest stoc$s. 1ot always so! though! warns the
chairman of the *E7. 0rders are not necessarily processed at the moment they are sent! and by the time the
1A%23
stoc$ is purchased! the price may have risen ten%fold. -ead more about investing through the /nternet and the
*E7s efforts to combat growing /nternet%based investment fraud at httpKGGwww.sec.gov.
Se%proCectK ;isit two on%line trading venuesK the more traditional 5errill 6ynch at www.merrill%lynch.com and
the newer ES.rade at www.etrade.com. 4ow well do these companies communicate the ris$s of a volatile
mar$et to their customersN 6oo$ing at the *E7s recommendations! how does each company rateN
1A%24

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