Chapter 11

Corporate Governance

Robert E. Hoskisson
Michael A. Hitt
R. Duane Ireland

©2004 by South-Western/Thomson Learning 1

The Strategic Management Process
Chapter 1
Strategic Chapter 2
Introduction to
Thinking Strategic Leadership
Strategic Management

Chapter 3 Chapter 4
Strategic Strategic Intent
The External The Internal
Analysis Environment Organization
Strategic Mission

Chapter 5 Chapter 6
Chapter 7
Business-Level Competitive Rivalry and
Creating Strategy Competitive Dynamics
Corporate-Level Strategy
Competitive
Advantage Chapter 8
Chapter 9 Chapter 10
Acquisition and
International Strategy Cooperative Strategy
Restructuring Strategies

Monitoring
And Creating Chapter 11 Chapter 12
Entrepreneurial Corporate Governance Strategic Entrepreneurship
2
Opportunities
 Discussion Questions
Click
Here 1. What is corporate governance? What are
the basic mechanisms that corporate
shareholders employ to exercise corporate
governance?
Click
Here 2. In an efficient separation between
shareholder and managerial control, what
roles do shareholders and top managers
play?
Click
Here
3. But what problem does this separation
create?
Click
Here More discussion questions 3
 Discussion Questions (cont.)
Click
Here 4. How does the agency problem relate
specifically to diversification strategy? How
does it relate to managerial risk taking in
general?
Click
Here
5. How do governance devices (shareholder
concentration, institutional shareholders,
boards of directors and managerial
compensation, and market for corporate
control) relate to controlling the agency
problem? Are there tradeoffs among these
devices?
Click
Here More discussion questions 4
 Discussion Questions (cont.)
Click
Here 6. How does corporate governance differ
in Germany and Japan?
Click
Here 7. How important is ethics in corporate
governance?

5
Discussion Question 1
What is corporate governance?
What are the basic mechanisms
that corporate shareholders
employ to exercise corporate
governance?

6
Corporate Governance
 Corporate governance is
– a relationship among stakeholders that is used
to determine and control the strategic direction
and performance of organizations
– concerned with identifying ways to ensure that
strategic decisions are made effectively
– used in corporations to establish order between
the firm’s owners and its top-level managers

7
 Corporate Governance
Mechanisms
Internal Governance Mechanisms
Ownership concentration
– relative amounts of stock owned
by individual shareholders and
institutional investors
Board of Directors
– individuals responsible for
representing the firm’s owners by
monitoring top-level managers’
strategic decisions

8
 Corporate Governance
Mechanisms
Internal Governance Mechanisms
Executive Compensation
– use of salary, bonuses, and long-
term incentives to align managers’
interests with shareholders’
interests
 Monitoring by top-level managers
– they may obtain Board seats (not
in financial institutions)
– they may elect Board
representatives
9
 Corporate Governance
Mechanisms
External Governance Mechanisms
Market for Corporate Control
– the purchase of a firm that is
underperforming relative to
industry rivals in order to
improve its strategic
competitiveness

Click
Here Return to Discussion Questions 10
Discussion Question 2

In an efficient separation between

shareholder and managerial control,
what roles do shareholders and top
managers play?

11
Separation of Ownership and
Managerial Control Return to
Discussion
Click
Here

 Basis of the modern corporation Questions

– shareholders purchase stock, becoming
residual claimants
– shareholders reduce risk by holding
diversified portfolios
– professional managers are contracted to
provide decision-making
 Modern public corporation form leads to
efficient specialization of tasks
– risk bearing by shareholders
– strategy development and decision-making by
managers 12
Discussion Question 3

But what problem does this

separation create?

13
Agency Relationship: Owners and
Managers
Shareholders
(Principals)
• Firm owners

14
Agency Relationship: Owners and
Managers
Shareholders
(Principals)
• Firm owners

Managers
• Decision makers
(Agents)

15
Agency Relationship: Owners and
Managers
Shareholders
(Principals)
• Firm owners

Managers
• Decision makers
(Agents)

• Risk bearing specialist (principal)

pays compensation to An Agency
Relationship
• A managerial decision-making
specialist (agent) 16
Agency Theory Problem Click
Here Return to
Discussion
 The agency problem occurs when: Questions
– the desires or goals of the principal and agent
conflict and it is difficult or expensive for the
principal to verify that the agent has behaved
inappropriately
 Solution:
– principals engage in incentive-based performance
contracts
– monitoring mechanisms such as the board of
directors
– enforcement mechanisms such as the managerial
labor market to mitigate the agency problem

17
Discussion Question 4

How does the agency problem

relate specifically to diversification
strategy? How does it relate to
managerial risk taking in general?

18
Manager and Shareholder Risk
and Diversification
Shareholder Managerial
(business) (employment)
S risk profile risk profile M
Risk

A B
Dominant Related Related Unrelated
Business Constrained Linked Businesses
Diversification 19
Agency Theory Conflicts
 Principals may engage in monitoring behavior to
assess the activities and decisions of managers
However, dispersed shareholding makes it
difficult and inefficient to monitor management’s
behavior
 Boards of Directors have a fiduciary duty to
shareholders to monitor management
However, Boards of Directors are often accused
of being lax in performing this function

Click
Here Return to Discussion Questions 20
 Discussion Question 5
How do governance devices (shareholder
concentration, institutional shareholders,
boards of directors and managerial
compensation, and market for corporate
control) relate to controlling the agency
problem? Are there tradeoffs among these
devices?

21
Governance Mechanisms
Ownership • Large block shareholders (often
Concentration institutional owners) have a strong
incentive to monitor management
closely
• Their large stakes make it worth
their while to spend time, effort and
expense to monitor closely
• They may also obtain Board seats
which enhances their ability to
monitor effectively (although
financial institutions are legally
forbidden from directly holding
board seats)
22
Governance Mechanisms
Ownership Insiders
Concentration • The firm’s CEO and other top-level
managers
Board of Related Outsiders
Directors • Individuals not involved with day-
to-day operations, but who have a
relationship with the company
Outsiders
• Individuals who are independent of
the firm’s day-to-day operations
and other relationships
23
Governance Mechanisms
Ownership Recommendations for more effective
Concentration Board Governance:
• Increase diversity of board
Board of members’ backgrounds
• Strengthen internal management
Directors
and accounting control systems
• Establish formal processes for
evaluation of the board’s
performance

24
Governance Mechanisms
Ownership • Salary, bonuses, long term incentive
Concentration compensation
• Executive decisions are complex and
Board of non-routine
• Many factors intervene making it
Directors difficult to establish how managerial
decisions are directly responsible for
Executive outcomes
Compensation

25
Governance Mechanisms
Ownership • Stock ownership (long-term
incentive compensation) makes
Concentration managers more susceptible to
market changes which are partially
Board of beyond their control
Directors • Incentive systems do not guarantee
that managers make the “right”
Executive decisions, but do increase the
Compensation likelihood that managers will do the
things for which they are rewarded

26
Governance Mechanisms
Ownership • Firms face the risk of takeover
Concentration when they are operated inefficiently
• Many firms begin to operate more
Board of efficiently as a result of the “threat”
Directors of takeover, even though the actual
incidence of hostile takeovers is
Executive relatively small
• Changes in regulations have made
Compensation
hostile takeovers difficult
• Acts as an important source of
Market for
discipline over managerial
Corporate Control incompetence and waste

27
Managerial Defense Tactics
 Designed to fend off the takeover attempt
 Increase the costs of making the
acquisitions
 Causes incumbent management to
become entrenched while reducing the
chances of introducing a new
management team
 May require asset restructuring
 Institutional investors oppose the use of
defense tactics
Click
Here Return to Discussion Questions 28
Discussion Question 6

How does corporate governance

differ in Germany and Japan?

29
International Corporate
Governance: Germany
 Owner and manager are often the same in
private firms
 Public firms often have a dominant
shareholder, frequently a bank
 Frequently there is less emphasis on
shareholder value than in U.S. firms,
although this may be changing

30
International Corporate
Governance: Germany
 Medium to large firms have a two-tiered
board
– vorstand monitors and controls managerial
decisions
– aufsichtsrat selects the Vorstand
– employees, union members and shareholders
appoint members to the Aufsichtsrat

31
International Corporate
Governance: Japan
 Obligation, “family” and consensus are
important factors
 Banks (especially “main bank”) are highly
influential with firm’s managers
 Keiretsus are strongly interrelated groups
of firms tied together by cross-
shareholdings

32
International Corporate
Governance: Japan
 Other characteristics:
– powerful government intervention
– close relationships between firms and
government sectors
– passive and stable shareholders who exert
little control
– virtual absence of external market for
corporate control

Click
Here Return to Discussion Questions 33
Discussion Question 7

How important is ethics in

corporate governance?

34
Corporate Governance and
Ethical Behavior
It is important to serve the interests
of the firm’s multiple stakeholder
groups!
• In the U.S., shareholders (in the capital
Capital Market market stakeholder group) are viewed as
Stakeholders the most important stakeholder group
• which are served by the board of
directors
• Hence, the focus of governance
mechanisms is on the control of
managerial decisions to ensure that
shareholders’ interests will be served
35
Corporate Governance and
Ethical Behavior
It is important to serve the interests
of the firm’s multiple stakeholder
groups!
• Product market stakeholders (customers,
Capital Market suppliers and host communities) and
Stakeholders organizational stakeholders (managerial
and non-managerial employees) are also
Product Market important stakeholder groups
Stakeholders

36
Corporate Governance and
Ethical Behavior
It is important to serve the interests
of the firm’s multiple stakeholder
groups!
• Although the idea is subject to debate,
Capital Market some believe that ethically responsible
Stakeholders companies design and use governance
mechanisms that serve all stakeholders’
Product Market interests
Stakeholders • Importance of maintaining ethical
behavior through governance
Organizational mechanisms is seen in the example of
Stakeholders Enron and Arthur Andersen
37