Strategic Management: Concepts and Cases

1
Strategic Management Concepts and Cases

• Part III Strategic Actions Strategy
  Implementation
• Chapter 10 Corporate Governance

2
The Strategic Management Process
3
Chapter 10 Corporate Governance (CG)

• Overview Eight content areas
• Define CG and its monitor/control of managers
  decisions
• Separation between ownership and management
  control
• Agency relationship and managerial opportunism
• Three internal governance mechanisms used to
  monitor/control management decisions
• External corporate governance mechanisms
• management restraint
• Executive compensation - types and effects
• Use of external CG in international settings
• How CG fosters ethical strategic decisions

4
CG and Its Effect on the Lives of CEOs

• In 2006 record number of CEOs lost jobs
• Dismissal
• Retirement
• Recruitment to another firm
• Partly due to increasing scrutiny by
• Boards
• Governance activists
• Increased pressure from the market for corporate
  control
• Media
• Trend decrease in average tenure (current
  18-24 mo.)
• Result CEOs looking at short-term vs. long-term

5
CG and Its Effect on the Lives of CEOs (Contd)

• CEOs now serving on fewer external boards
• CG Double-edged sword
• Can put an end to scandals
• Might restrictive CEOs (i.e., they wont take
  risks)

6
Chapter 10 Corporate Governance (CG)

• Overview Eight content areas
• Define CG and its monitor/control of managers
  decisions
• Separation between ownership and management
  control
• Agency relationship and managerial opportunism
• Three internal governance mechanisms used to
  monitor/control management decisions
• External corporate governance mechanisms
• management restraint
• Executive compensation - types and effects
• Use of external CG in international settings
• How CG fosters ethical strategic decisions

7
Introduction

• Corporate Governance (CG)
• Set of mechanisms used to manage the
  relationships (and conflicting interests) among
  stakeholders, and to determine and control the
  strategic direction and performance of
  organizations (aligning strategic decisions with
  company values)
• Effective CG interest to nations as it reflects
  societal standards
• Firms shareholders are treated as key
  stakeholders as they are the companys legal
  owners

8
Chapter 10 Corporate Governance (CG)

• Overview Eight content areas
• Define CG and its monitor/control of managers
  decisions
• Separation between ownership and management
  control
• Agency relationship and managerial opportunism
• Three internal governance mechanisms used to
  monitor/control management decisions
• External corporate governance mechanisms
• management restraint
• Executive compensation - types and effects
• Use of external CG in international settings
• How CG fosters ethical strategic decisions

9
Separation of Ownership and Managerial Control

• Introduction
• Historically, firms managed by founder-owners
  descendants
• Separation of ownership and managerial control
  allow shareholders to purchase stock, entitling
  them to income (residual returns) implies
  risk for this group who manage their investment
  risk
• Shareholder value reflected in price of stock

10
Separation of Ownership and Managerial Control
(Contd)

• Introduction
• Small firms managers are high percentage owners,
  which implies less separation between ownership
  and management control
• Usually implies family-owned businesses
• This group faces 2 critical issues
• 1. As they grow, they may not have access to
  all needed skills to manage the growing firm and
  maximize its returns, so may need outsiders to
  improve management
• 2. May need to seek outside capital (whereby
  they give up some ownership control)

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Separation of Ownership and Managerial Control
(Contd)

• Agency relationships
• Relationships between business owners
  (principals) and decision-making specialists
  (agents) hired to manage principals' operations
  and maximize returns on investment (and focus of
  this chapter)
• Other agency relationship examples
  Consultants/clients insured/insurer
  manager/employee

12
Separation of Ownership and Managerial Control
(Contd)

• Agency relationships (Contd)
• Managerial Opportunism Seeking self-interest
  with guile (i.e., cunning or deceit)
• Opportunism an attitude and set of behaviors
• Managers dont know which agents will enact
  managerial opportunism
• Principals establish governance and control
  mechanisms to prevent agents from acting
  opportunistically

13
An Agency Relationship
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Separation of Ownership and Managerial Control
(Contd)

• Agency problems Product diversification
• Can result in 2 manager benefits shareholders
  dont enjoy
• 1. Increase in firm size
• 2. Firm portfolio diversification which can
  reduce top executives employment risk (i.e., job
  loss, loss of compensation and loss of managerial
  reputation)
• Diversification reduces these risks because a
  firm and its managers are less vulnerable to the
  reduction in demand associated with a single or
  limited number of product lines or businesses

15
Separation of Ownership and Managerial Control
(Contd)

• Agency problems Firms free cash flow
• Resources remaining after the firm has invested
  in all projects that have positive net present
  values within its current businesses
• Available cash flows
• Managerial inclination to overdiversify can be
  acted upon
• Shareholders may prefer distribution as
  dividends, so they can control how the cash is
  invested
• Curve S depicts shareholders optimal level of
  diversification where Point A is preferred by
  shareholders and Point B by top executives

16
Manager and Shareholder Risk and Diversification
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Separation of Ownership and Managerial Control
(Contd)

• Agency costs and governance mechanisms
• 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
• Costs associated with agency relationships, and
  effective governance mechanisms should be
  employed to improve managerial decision making
  and strategic effectiveness
• Sarbanes-Oxley Act

18
Ownership Concentration

• Introduction Key concepts
• 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
  corporations issued shares
• Institutional Owners Financial institutions such
  as stock mutual funds and pension funds that
  control large-block shareholder positions

19
Ownership Concentration (Contd)

• Introduction Key concepts
• Institutional Owners (Contd)
• The growing influence of institutional owners
• Provides size to influence strategy and the
  incentive to discipline ineffective managers
• Increased shareholder activism supported by SEC
  rulings in support of shareholder involvement and
  control of managerial decisions

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The Board of Directors (BOD)

• Introduction
• Group of shareholder-elected individuals (usually
  called directors) whose primary responsibility
  is to act in the owners interests by formally
  monitoring and controlling the corporations
  top-level executives

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The Board of Directors (BOD) (Contd)

• As stewards of an organization's resources, an
  effective and well-structured board of directors
  can influence the performance of a firm
• Oversee managers to ensure the company is
  operated in ways to maximize shareholder wealth
• Direct the affairs of the organization
• Punish and reward managers
• Protect shareholders rights and interests
• Protect owners from managerial opportunism
• 3 types Insider, related outsider and outsider

22
The Board of Directors (BOD) (Contd)

• Historically, BOD dominated by inside managers
• Managers suspected of using their power to select
  and compensate directors
• NYSE implemented an audit committee rule
  requiring outside directors to head audit
  committee (a response to SECs proposal requiring
  audit committees be made up of outside directors)
• Sarbanes-Oxley Act passed leading to BOD changes
• CG becoming more intense through BOD mechanism
• BOD scandals led to trend of separating roles of
  CEO and Chairperson

23
The Board of Directors (BOD) (Contd)

• Outside directors
• Improve weak managerial monitoring and control
  that corresponds to inside directors
• Tend to emphasize financial controls, to the
  detriment of risk-related decisions by managers,
  as they do not have access to daily operations
  and a high level of information about managers
  and strategy

24
The Board of Directors (BOD) (Contd)

• Outside directors (Contd)
• Large number of outsiders can create problems
• Limited contact with the firms day-to-day
  operations and incomplete information about
  managers
• results in ineffective assessments of managerial
  decisions and initiatives.
• emphasizes financial, as opposed to strategic,
  controls to gather performance information to
  evaluate performance of managers business
  units, which could reduce RD investments,
  increase diversification, and pursue higher
  compensation to offset their employment risk

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The Board of Directors (BOD) (Contd)

• Enhancing BOD effectiveness (N5 changes)
• Increased diversity in board members backgrounds
  
• Establishment and consistent use of formal
  processes to evaluate the boards performance
• Creation of a lead director role that has
  strong agenda-setting and oversight powers
• Modified compensation of directors
• Requires that directors own significant stakes in
  the company in order to keep focused on
  shareholder interests

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Chapter 10 Corporate Governance (CG)

• Overview Eight content areas
• Define CG and its monitor/control of managers
  decisions
• Separation between ownership and management
  control
• Agency relationship and managerial opportunism
• Three internal governance mechanisms used to
  monitor/control management decisions
• External corporate governance mechanisms
• management restraint
• Executive compensation - types and effects
• Use of external CG in international settings
• How CG fosters ethical strategic decisions

27
Executive Compensation (EC)

• Executive compensation (EC)
• Defined Governance mechanism that seeks to align
  the interests of top managers and owners through
  salaries, bonuses, and long-term incentive
  compensation, such as stock awards and stock
  options
• Thought to be excessive and out of line with
  performance
• Alignment of pay and performance complicated
  board responsibility
• The effectiveness of pay plans as a governance
  mechanism is suspect

28
Executive Compensation (EC) (Contd)

• The effectiveness of executive compensation
• Complicated, especially long-term incentive comp
• The quality of complex and nonroutine strategic
  decisions that top-level managers make is
  difficult to evaluate
• Decisions affect financial outcomes over an
  extended period, making it difficult to assess
  the effect of current decisions on corporation
  performance
• External factors affect a firms performance in
  addition to top-level management decisions and
  behavior

29
Executive Compensation (EC) (Contd)

• The effectiveness of executive compensation
  (Contd)
• Performance-based compensation used to motivate
  decisions that best serve shareholder interest
  are imperfect in their ability to monitor and
  control managers
• Incentive-based compensation plans intended to
  increase firm value, in line with shareholder
  expectations, subject to managerial manipulation
  to maximize managerial interests
• Many plans seemingly designed to maximize manager
  wealth rather than guarantee a high stock price
  that aligns the interests of managers and
  shareholders

30
Executive Compensation (EC) (Contd)

• The effectiveness of executive compensation
  (Contd)
• Stock options are highly popular
• Repricing strike price value of options is
  commonly lowered from its original position
• Backdating options grant is commonly dated
  earlier than actually drawn up to ensure an
  attractive exercise price

31
Market for Corporate Control

• Market for Corporate Control
• Definition external governance mechanism
  consisting of a set of potential owners seeking
  to acquire undervalued firms and earn
  above-average returns on their investments
• Becomes active when a firms internal controls
  fail
• Need (for external mechanisms) exists to
• address weak internal corporate governance
• correct suboptimal performance relative to
  competitors, and
• discipline ineffective or opportunistic managers.
• External mechanisms are less precise than
  internal governance mechanisms

32
Market for Corporate Control

• Managerial defense tactics
• Hostile takeovers are the major activity
• Not always due to poor performance
• Consequent to tactics are the defenses

33
Chapter 10 Corporate Governance (CG)

• Overview Eight content areas
• Define CG and its monitor/control of managers
  decisions
• Separation between ownership and management
  control
• Agency relationship and managerial opportunism
• Three internal governance mechanisms used to
  monitor/control management decisions
• External corporate governance mechanisms
• management restraint
• Executive compensation - types and effects
• Use of external CG in international settings
• How CG fosters ethical strategic decisions

34
International Corporate Governance

• 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

35
International Corporate Governance (Contd)

• 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

36
International Corporate Governance (Contd)

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

37
Chapter 10 Corporate Governance (CG)

• Overview Eight content areas
• Define CG and its monitor/control of managers
  decisions
• Separation between ownership and management
  control
• Agency relationship and managerial opportunism
• Three internal governance mechanisms used to
  monitor/control management decisions
• External corporate governance mechanisms
• management restraint
• Executive compensation - types and effects
• Use of external CG in international settings
• How CG fosters ethical strategic decisions

38
Governance Mechanisms and Ethical Behavior

• It is important to serve the interest of the
  firms multiple stakeholder groups
• In the U.S., shareholders (in the capital market
  stakeholder group) are the most important
  stakeholder group served by the board of
  directors
• Governance mechanisms focus on control of
  managerial decisions to protect shareholders
  interests

39
Governance Mechanisms and Ethical Behavior
(Contd)

• Product market stakeholders (customers, suppliers
  and host communities) and organizational
  stakeholders (managerial and non-managerial
  employees) are also important 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 just remember
  Enron and Arthur Andersen!