Competing for Advantage

1. Competing for Advantage Chapter 11 Corporate Governance PART IV MONITORING AND CREATING ENTREPRENEURIAL OPPORTUNITIES

2. The Strategic Management Process

3. Corporate Governance • Key Terms • Corporate governance Set of mechanisms used to manage the relationships among stakeholders and to determine and control the strategic direction and performance of organizations

4. Governance Mechanisms

5. Separation of Ownership and Managerial Control Founder-Owners Family-Owned Firms Modern Public Corporations

6. Agency Relationships • Key Terms • Agency relationship Relationship which exists when one or more people (principals) hire another person or people (agents)as decision-making specialists to perform a service • Managerial opportunism Seeking self-interest with guile (i.e., cunning or deceit)

7. An Agency Relationship

8. The Agency Problem The agency problem occurs when the desires or goals of the principal and agent conflict and it is difficult or expensive for the principal to verify whether the agent has behaved inappropriately.

9. Problems with Separate Ownership and Control • Principal and the agent having different interests and goals • Shareholders lacking direct control in large publicly traded corporations • Agent making decisions which result in actions that conflict with interests of the principal

10. Product Diversification as an Agency Problem • Interests of Top Executives • Increased compensation • Reduced employment risk • Interests of Shareholders • Increased value of firm • Reduced risk of firm failure

11. Use of Free Cash Flows • The managerial inclination to overdiversify can be acted upon when free cash flows are available. • Shareholders may prefer that free cash flows be distributed to them as dividends, so they can control how the cash is invested. • Free cash flows are resources remaining after the firm has invested in all projects that have positive net present values within its current businesses.

12. Manager and Shareholder Risk and Diversification

13. Agency Costs and Governance Mechanisms • Key Terms • Agency costs The sum of incentive costs, monitoring costs, enforcement costs, and individual financial losses incurred by principals, because governance mechanisms cannot guarantee total compliance by the agent

14. Regulatory Oversight of Corporate Governance • 2002 Sarbanes-Oxley (SOX) Act • 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank)

15. Dodd-Frank Provisions • Creates a Financial Stability Oversight Council headed by the Treasury Secretary • Establishes a new system for liquidation of certain financial companies • Provides for a new framework to regulate derivatives • Establishes new corporate governance requirements • Regulates credit rating agencies and securitizations • Establishes a new consumer protection bureau, providing for extensive consumer protection in financial services

16. Ownership Concentration • Key Terms • Ownership concentration Governance mechanism defined by both the number of large-block shareholders and the total percentage of shares they own • Large block shareholders Shareholders owning a concentration of at least 5 percent of a corporation’s issued shares

17. Effects of Ownership Concentration • Diffuse ownership produces weak monitoring of managers’ decisions. • Ownership concentration is associated with lower levels of firm product diversification. • High degrees of ownership concentration improve the probability that managers’ strategic decisions will increase shareholder value. • In general, ownership concentration’s influence on strategies and firm performance is positive.

18. Influence of Institutional Owners • Key Terms • Institutional owners Financial institutions such as stock mutual funds and pension funds that control large-block shareholder positions

19. Influence of Institutional Owners • Becoming more active in efforts to influence the corporation’s strategic decisions • Initially focused on CEO performance and accountability • Now targeting ineffective boards of directors and executive compensation policies • Growing efforts to expand shareholders’ decision rights

20. Board of Directors • Key Terms • Board of directors Group of shareholder-elected individuals whose primary responsibility is to act in the owners’ interests by formally monitoring and controlling the corporation’s top-level executives

21. Board of Director Responsibilities • Direct the affairs of the organization • Punish and reward managers • Protect shareholders’ rights and interests • Protect owners from managerial opportunism

22. Classifications of Boards of Directors’ Members

23. Outsider Directors • Enhance managerial monitoring • Contribute to strategic direction • Provide valuable links to external stakeholders • Promoted by regulatory agencies • Do not guarantee high performance

24. Problems with Outsider-Dominated Boards • Limited access to daily operations and critical information • May lack insights required to fully and perhaps effectively evaluate manager decisions and initiatives • Tendency to emphasize financial controls • Shifts risk to top-level managers • Can increase detrimental managerial actions

25. Trends Among Boards • Background diversity • Formal processes to evaluate board performance • “Lead director” role with strong agenda-setting and oversight powers • Changes in compensation packages • Ownership stake requirements • Demand for greater accountability and improved performance • Social networks with external stakeholders

26. Board Effectiveness • Become engaged in the firm, without trying to micromanage it • Challenge the reasoning behind decisions, but be supportive of decisions that are made • Provide an independent perspective on important decisions

27. Executive Compensation • Key Terms • Executive compensation Governance mechanism that seeks to align the interests of top managers and owners through salaries, bonuses, and long-term incentive compensation, such as restricted stock awards and stock options

28. Executive Compensation Issues • High visibility and controversy surrounding CEO pay • Downward pressure from shareholders and activists • Relationship to performance • Long-term incentive plans • Effective governance mechanism for firms implementing international strategies

29. Executive Compensation for International Strategies • Pay levels vary by regions of the world. • Owners of multinational corporations may be best served with less uniformity across the firm’s foreign subsidiaries. • Multiple compensation plans increase the need for monitoring and other related agency costs. • Complexity and potential dissatisfaction increase as corporations acquire firms in other countries.

30. Long-Term Incentive Plans • Address potential agency problems • Viewed positively by the stock market • Reduce pressure for changes in the board • Reduce pressure for outside directors • Assumed to effectively link executive pay with firm performance

31. The Effectiveness of Executive Compensation • It is difficult to evaluate complex and nonroutine strategic decisions made by top-level managers. • It is difficult to assess the long-term strategic effect of current decisions which affect financial performance outcomes over an extended period. • Multiple external factors affect a firm’s performance other than top-level managerial decisions and behavior.

32. The Effectiveness of Executive Compensation • Performance-based (incentive) compensation plans are imperfect in their ability to monitor and control managers. • Conflicting short-term and long-term objectives have a complex effect on managerial decisions and behaviors. • Excessive compensations correlate with weak corporate governance.

33. Executive Compensation – A Question of Stock Issue Effectiveness • Manager wealth v. high stock prices • Earnings manipulations • Risk taking • Repricing • Backdating

34. Market for Corporate Control • Key Terms • Market for corporate control An external governance mechanism which is composed of individuals and firms that buy ownership positions in or take over potentially undervalued corporations so they can form new divisions in established diversified companies or merge two previously separate firms

35. Market for Corporate Control • Addresses weak internal corporate governance • Corrects suboptimal performance relative to competitors • Disciplines ineffective or opportunistic managers

36. Hostile Takeover Defense Strategies

37. Market for Corporate Control • May not be entirely efficient • Lacks the precision of internal governance mechanisms • Can be an effective constraint on questionable manager motives

38. International Corporate Governance • Similarities among governance structures in industrialized nations are increasing. • Firms using an international strategy must understand the dissimilarities in order to operate effectively in different international markets. • Traditional governance structures in foreign nations, like Germany and Japan, are being affected by global competition.

39. Corporate Governance in Germany • Concentration of ownership is strong. • Banks exercise significant power as a source of financing for firms. • Two-tiered board structures, required for larger employers, place responsibility for monitoring and controlling managerial decisions and actions with separate groups. • Power sharing includes representation from the community as well as unions.

40. Corporate Governance in Japan • Cultural concepts of obligation, family, and consensus affect attitudes toward governance. • Close relationships between stakeholders and a company are manifested in cross-shareholding and can negatively impact efficiencies. • Banks play an important role in financing and monitoring large public firms. • Despite the counter-cultural nature of corporate takeovers, changes in corporate governance have introduced this practice.

41. Global Corporate Governance • Relatively uniform governance structures are evolving in developed countries. • These structures are moving closer to the U.S. model of corporate governance. • Although implementation is slower, this merging with U.S. practices is occurring even in transitional economies.

42. Capital Market Stakeholders The Firm Corporate Governance and Ethical Behavior • In the U.S., shareholders (in the capital market stakeholder group) are viewed as the most important stakeholder group 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.

43. Product Market Stakeholders The Firm Organizational Stakeholders Corporate Governance and Ethical Behavior It is important to serve the interests of the firm’s multiple stakeholder groups. • Product market stakeholders (customers, suppliers, and host communities) and organizational stakeholders (managerial and non-managerial employees) are also important stakeholder groups.

44. Capital Market Stakeholders Product Market Stakeholders The Firm Organizational Stakeholders 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, some believe that ethically responsible companies design and use governance mechanisms that serve all stakeholders’ interests. • Importance of maintaining ethical behavior through governance mechanisms is seen in the examples of recent corporate scandals.

45. Corporate Governance and Ethical Behavior • Design CEO pay structure with long-term focus • Actively set boundaries for ethical behavior • Actively define organization’s values • Clearly communicate expectations to all stakeholders • Foster an ethical culture of accountability • Promote CEOs as positive role models • Monitor ethical behavior of top executives • Do not stifle manager flexibility and entrepreneurship

46. Ethical Question Do managers have an ethical responsibility to push aside their own values with regard to how certain stakeholders are treated (i.e., special interest groups) in order to maximize shareholder returns?

47. Ethical Question What are the ethical implications associated with owners assuming that managers will act in their own self-interest?

48. Ethical Question What ethical issues surround executive compensation? How can we determine whether top executives are paid too much?

49. Ethical Question Is it ethical for firms involved in the market for corporate control to target companies performing at levels exceeding the industry average? Why or why not?

50. Ethical Question What ethical issues, if any, do top executives face when asking their firm to provide them with a golden parachute?