MAN 4720 Huning Chapter 12: Corporate Governance and Business Ethics
Milton Friedman's Philosophy
"The social responsibility of business is to increase its profits." A survey was created: •For the (degreed) top 25% of income earners •To assess various countries •To inquire whether they agree with Milton Friedman The results...
Corporate Mechanisms to Align Incentives Between Principals & Agents
1. Executive compensation 2. The market for corporate control 3. Financial statement auditors, government regulators, and industry analysts
Michael Porter's Recommendations to Reconnect Economic & Societal Needs
1.Expand the customer base • Bring in nonconsumers such as those at the bottom of the pyramid (large / poor socioeconomic group). 2.Expand traditional internal firm value chains. • Include more nontraditional partners such as nongovernmental organizations (NGOs). 3.Focus on creating new regional clusters: • Such as Silicon Valley in the United States • Electronic City in Bangalore, India • Chilecon Valley in Santiago, Chile Porter argues that these strategic actions will lead to a larger pie of revenues and profits that can be distributed among a company's stakeholders.
The Shared Value Creation Framework
A model proposing that managers have a dual focus on: •Shareholder value creation •Value creation for society Example: GE's ecomagination initiative •To provide cleaner and more efficient sources of energy •To provide abundant sources of clean water anywhere in the world •To reduce emissions
Agency Theory
A theory that views the firm as a nexus of legal contracts •Conflicts that arise should be resolve legally. •The firm needs to design work tasks, incentives, and employment contracts. •To minimize opportunism by agents Senior executives, such as the CEO, face agency problems when they delegate authority. Employees who perform the actual operational labor are agents who work on behalf of the managers. Such frontline employees often enjoy an informational advantage over management. They may tell their supervisor that it took longer to complete a project or serve a customer than it actually did, for example. Some employees may be tempted to use such informational advantage for their own self-interest (e.g., spending time on Facebook during work hours, watching YouTube videos, or using the company's computer and internet connection for personal business).
The Market for Corporate Control
An external corporate-governance mechanism Activist investors who: •Seek to gain control of an underperforming corporation •Buy shares of its stock in the open market •Through leveraged buy outs •Defended by poison pills In a leveraged buyout (LBO), a single investor or group of investors buys, with the help of borrowed money (leveraged against the company's assets), the outstanding shares of a publicly traded company in order to take it private. In short, an LBO changes the ownership structure of a company from public to private. The expectation is often that the private owners will restructure the company and eventually take it public again through an initial public offering (IPO). To avoid being taken over against their consent, some firms put in place a poison pill. These are defensive provisions that kick in should a buyer reach a certain level of share ownership without top management approval. Typically, such a plan gives shareholders the right to buy more shares at a discount if one shareholder buys a certain percentage or more of the company's shares. The plan could be triggered, for instance, if any one shareholder buys 20% of the company's shares, at which point every shareholder (except the one who possesses 20%) will have the right to buy a new issue of shares at a discount. If every other shareholder is able to buy more shares at a discount, such purchases would dilute the bidder's interest, and the cost of the bid would rise substantially. Knowing that such a plan could be activated, the bidder could be disinclined to take over the corporation without the board's approval, and would first negotiate with the board in order to revoke the plan.[1]
What the MBA Oath Says
As a business leader I recognize my role in society. •My purpose is to lead people and manage resources to create value that no single individual can create alone. •My decisions affect the well-being of individuals inside and outside my enterprise, today and tomorrow. Therefore, I promise that: •I will manage my enterprise with loyalty and care, and will not advance my personal interests at the expense of my enterprise or society. •I will understand and uphold, in letter and spirit, the laws and contracts governing my conduct and that of my enterprise. •I will refrain from corruption, unfair competition, or business practices harmful to society. •I will protect the human rights and dignity of all people affected by my enterprise, and I will oppose discrimination and exploitation. •I will protect the right of future generations to advance their standard of living and enjoy a healthy planet. •I will report the performance and risks of my enterprise accurately and honestly. •I will invest in developing myself and others, helping the management profession continue to advance and create sustainable and inclusive prosperity. •In exercising my professional duties according to these principles, I recognize that my behavior must set an example of integrity, eliciting trust and esteem from those I serve. I will remain accountable to my peers and to society for my actions and for upholding these standards. This oath I make freely, and upon my honor.
Other Governance Mechanisms
Auditors, government regulators, and industry analysts SEC- GAAP as reported publicly via EDGAR The Wall Street Journal, Bloomberg BusinessWeek, Forbes... GovernanceMetrics International (GMI Ratings) The market for corporate control External governance mechanism Hostile takeover Corporate raiders and hedge funds 2013 − Dell's LBO was a target of Carl Icahn.
Bad Apples vs. Bad Barrels
Bad Apples •Individuals who act opportunistically Bad Barrels •An unethical organizational climate To set the ethical tone, leaders must: •Set clear ethical expectations •Put structure, culture and control systems in place •Culture must be aligned •Executive behavior must adhere to values
Adverse Selection and Moral Hazard
Both caused by information asymmetry Adverse Selection •An increased likelihood of selecting inferior alternatives Moral Hazard •When one party is incentivized to take undue risks or shirk responsibilities because the costs incur to the another party
Strategy and Business Ethics
Business ethics Agreed-upon explicit code of conduct in business Legal conduct vs. Ethical conduct Legal (min acceptable standard), but may not be ethical Mortgage brokers selling "option ARMs" Ethical, but may not be legal Pharmaceutical firms discussing pricing to increase affordability
Corporate Governance
Corporate governance Mechanisms to direct and control a firm Ensure the pursuit of strategic goal Address the principal−agent problem Ask tough questions when needed When corporate governance fails Accounting scandal Global financial crisis Information asymmetry Insider information: Galleon Group On-the-job consumption: Tyco & Merrill Lynch Insider trading is an example of information asymmetry. In October 2011, Mr. Raj Rajaratnam, a co-founder of the Galleon Group was sentenced to 11 years in U.S. jail for insider trading. This is one of the longest terms ever for this offense.
Strategy Highlight: Goldman Sachs
Did Goldman Sachs and the "Fabulous Fab" Commit Securities Fraud? In 2010, the SEC sued the company and an employee, named Fabrice Tourre, for fraud •Did the bank knowingly mislead investors? •Goldman Sachs argued that it is up to clients to assess risk involved in investments. Public pressure mounted. •Goldman Sachs ended up paying $550M to settle the lawsuit, but did not admit wrongdoing. Tourre was convicted of fraud.
Auditors, Government Regulators, And Industry Analysts
External-governance mechanisms To avoid misrepresentation of financial results: •Public financial statements must follow GAAP: •Generally accepted accounting principles •Financial statements must be audited Industry analysts often base their buy, hold, or sell recommendations on: •Financial statements filed with the SEC Business news (WSJ, Forbes, CNBC, etc.) Corporate-governance mechanisms play an important part in aligning the interests of principals and agents. They enable closer monitoring and controlling, as well as provide incentives to align interests of principals and agents. An industry has sprung up around assessing the effectiveness of corporate governance in individual firms. Research outfits, such as GMI Ratings, provide independent corporate governance ratings. The ratings from these external watchdog organizations inform a wide range of stakeholders, including investors, insurers, auditors, regulators, and others.
Strategy Highlight: GE's Board of Directors
GE's board consists of: •Members of companies, academia, and government •16 members, 5 different committees They meet about 12 times annually 25% of the board are women (more than usual) •Generally, the larger the company, the greater its gender diversity. •Diverse boards are less likely to fall victim to groupthink. Generally, the larger the company, the greater its gender diversity, as demonstrated in recent years by tracking different levels of the Fortune 1000. For example, in 2014 boards of the Fortune 100 companies averaged 22 percent gender diversity; of Fortune 500 (as noted), 19 percent; and of the bottom half of the Fortune 1000, 16. Percent. GE as of this writing ranks number eight in the Fortune 1000 rankings in terms of gender diversity.
Responsibilities of the Board of Directors
General strategic oversight and guidance Selecting, evaluating, and compensating the CEO •The board may fire him or her. •Overseeing the company's CEO succession plan Providing guidance for executive compensation Reviewing, monitoring, evaluating, and approving strategic initiatives •Such as large acquisitions Risk assessment & mitigation Ensuring a firm's audited financial statements Ensuring a firm's compliance with laws and regulations
Chapter Case: HP Saga
HP's Boardroom Soap Opera Continues $120 billion in sales "The HP Way" - an admired corporate culture (1938) Mark Hurd became CEO in 2005. Good financial results - lower costs & higher sales 18-month period, HP's market value dropped 80% $105 billion (April '10) to $23 billion (November '12) Leo Apotheker became CEO in Fall 2010. Meg Whitman became CEO in Fall 2011. 2006 First Stage - HP-initiated unethical surveillance to uncover a suspected leak. 2010 (summer) Second Stage - Jodie Fisher, a former adult-movie actress, filed a lawsuit against CEO Mark Hurd. 2010 (fall) Third Stage - (new) CEO Leo Apotheker overpaid for British software company Autonomy ($11B). HP took nearly $9 billion write-down for this within a year! The CEO of HP, Mark Hurd, resigned due to his involvement in a sex scandal with an adult movie actress, which severely damaged the company's image. The market value dropped roughly $10 billion, largely due to Mr. Hurd's forced resignation. This opening case is designed to illustrate the performance implications of ethical lapses and corporate governance missteps by the board of directors and senior executives.
The MBA Oath
Helps anchor future managers to professional values Has been taken by: •6,000 MBA students •Students in over 300 institutions around the world A guideline for integrity in business
When Facing an Ethical Dilemma
Is the action within acceptable norms of professional behavior? •As outlined in the organization's code of conduct •As defined by the profession at large Would you feel comfortable explaining and defending the decision in public? •How would the media react? •How would the company's stakeholders feel about it?
The Principal-Agent Problem
Managers, executives, and board members tend to have access to private information concerning important company developments that outsiders, especially investors, are not privy to. Often this informational advantage is based on timing—insiders are the first to learn about important developments before the information is released to the public. Although possessing insider information is not illegal and indeed is part of an executive's job, what is illegal is acting upon it through trading stocks or passing on the information to others who might do so. Insider-trading cases, therefore, provide an example of egregious exploitation of information asymmetry.
Creating Shared Value
Michael Porter's view: •Executives shouldn't concentrate only on increasing firm profits. •Rather, they should focus on creating shared value. •Economic value (for shareholders) •Social value (address society's needs and challenges) •Societal progress is important. •Capitalism helps shape society.
The Shared Value Creation Framework
Provides guidance to managers Helps reconcile: •Gaining and sustaining competitive advantage and •Corporate social responsibility
Business Ethics
Provides training for: •"behavior that is consistent with the principles, norms, and standards of business practice that have been agreed upon by society" Can differ in various cultures around the globe •Universal norms include: •Fairness, honesty, reciprocity Law and ethics, however, are not synonymous. This distinction is important and not always understood by the general public. Staying within the law is a minimum acceptable standard. A note of caution is therefore in order: A manager's actions can be completely legal, but ethically questionable.
The Board of Directors
Represent the interests of shareholders Tasked with providing oversight Consist of inside and outside directors •Inside directors: usually consist of: CEO, COO, CFO •Outside directors: senior execs from other firms •Interlocked; direct vs indirect Are elected by the shareholders •Shareholders vote to determine who is elected
Contrasting perspectives of "shareholder versus stakeholder" governance.
Shareholders focus on self-interest and profitability, while stakeholders emphasize responsibilities and all the parties involved. National and cultural differences play a role when designing the governance structure. German firms are more debt-financed than equity. Thus, large national banks are a major stakeholder and encourage maintaining a high level of employment. The closure of a plant in Germany is seen as the very last resort, whereas in the UK or U.S., layoffs and plant closures are more common.
Executive Compensation
Stock options are often part of compensation. The average ratio of CEO to employee pay is 300:1. •1980: 40-1 About 2/3 of CEO pay is linked to firm performance. •But this link is weak •Can further increase job stress •Can negatively impact job performance
Ethical Leadership Is Critical
Strategic leaders set the tone for the ethical climate within an organization. •Employees take cues from their environment on how to act. CEOs of Fortune 500 companies are under constant public scrutiny. •Ought to adhere to the highest ethical standards •Unethical behavior can destroy the CEO's reputation. Ethical expectations must be clear.
Chapter Case 12: Uber
The most valuable private start-up ever •Offers cab-hailing service via an app •Their unethical, perhaps illegal, activity generated controversy Uber's beginning •Started by two tech entrepreneurs Record breaking growth: •Successfully expanded both in the United States and globally to more than 500 cities in 70 countries •Revenue growth: $400 million in 2014 to $8 billion in 2017 Ethically challenged? •Uber is pushing the envelope of what is acceptable, ethical, and even legal with all its stakeholders. •Regulators, government, drivers, journalists, competitors Primary issues, among others: •Disregard for laws and regulations •Dynamic pricing: supply & demand vs. price gouging? •Competitive tactics: ordering rides from competitors, then canceling them Allegations of harassment and discrimination In 2017 the CEO stepped down •The company's reputation was faltering •Uber was considered it's worst competitor •Due to the actions of executives Has Uber embraced ethical standards required to operate as a large company? Only one other new venture—Facebook—has ever reached a $50 billion valuation for a private, venture-capital-backed firm. Facebook took seven years to reach this mark; Uber only five. If we compare Uber with car rental giant Hertz—with some 150 locations, a fleet of 500,000 cars, and about 30,000 employees—it's astounding to learn that Hertz reaches only about 1 percent of Uber's valuation!
The Public Stock Company: Four Benefits
The public stock company enjoys these four characteristics that make it an attractive corporate form. Limited liability for investors Transferability of investor ownership •Through the trading of shares of stock Legal personality •Rights and obligations Separation of legal ownership and management control
Percent of "Informed Public" Who "Strongly/Somewhat Agree" with Friedman
The survey asked the top 25 percent of income earners holding a university degree in each country surveyed whether they agree with Milton Friedman's philosophy that "the social responsibility of business is to increase its profits." The results, as displayed in this graph, revealed some intriguing national differences. United Arab Emirates: about 82 percent. Japan: 70 percent. India: a little less than 70 percent. South Korea: 66 percent. Singapore: 66 percent. United States: 55 percent. China: a little less than 40 percent, 38 percent. Brazil: about 37 percent. Germany: 35 percent. Italy: 34 percent. Spain: 33 percent. (approximate totals) The countries where the fewest people agreed with Friedman's philosophy were China, Brazil, Germany, Italy, and Spain; fewer than 40 percent of respondents in those countries supported an exclusive focus on shareholder capitalism. Although they have achieved a high standard of living, European countries such as Germany have tempered the free market system with a strong social element, leading to so-called social market economies. The respondents from these countries seemed to be more supportive of a stakeholder strategy approach to business. Some critics, however, would argue that too strong a focus on the social dimension contributed to the European debt crisis because sovereign governments such as Greece, Italy, and Spain took on unsustainable debt levels to fund social programs such as early retirement plans, government-funded health care, and so on. The United States placed roughly in the middle of the continuum—a bit more than half (56 percent) of U.S. respondents subscribed to Friedman's philosophy.
The Public Stock Company: Hierarchy of Authority
This image depicts the levels of hierarchy within a public stock company. The state or society grants a charter of incorporation to the company's shareholders—its legal owners, who own stock in the company. The shareholders appoint a board of directors to govern and oversee the firm's management. The managers hire, supervise, and coordinate employees to manufacture products and provide services.
Assume you work in the accounting department of a large software company. Toward the end of December, your supervisor tells you to change the dates on several executive stock option grants from March 15 to July 30. Why would she ask for this change? What should you do?
This seems like illegal and unethical tax evasive actions are being demanded by the supervisor. Unless there is some legitimate error in the stock option dating, the employee has every right to refuse to make these changes because of the liability issues. Further, if this request is condoned in the organization, it may be time to quit the job or contact the IRS to report the issue.
MILTON FRIEDMAN VS. MICHAEL PORTER
Traditional View: (Friedman) •Shareholder capitalism: shareholders - the providers of the necessary risk capital and the legal owners of public companies - have the most legitimate claim on profits. Shared Value View: (Porter) •Corporate social responsibility (CSR): obligations extend beyond the economic responsibility and include legal, ethical, and philanthropic societal expectations
Will the CEO's departure help Uber develop a more ethical and grounded corporate culture?
Will the CEO's departure help Uber develop a more ethical and grounded corporate culture? Current issues to consider: •The CEO has already had much influence •Uber is experiencing issues all over the globe •Investors may not allow Uber to cut ethical corners •Uber has had to deal with an exodus of talent •Is car ownership no longer needed due to Uber? •Will ride prices go down when Uber uses autonomous vehicles? Have you used a ride service like Uber? If so, how was your experience? What is Uber's business model / strategic intent? Is Uber "the most ethically challenged company in Silicon Valley"? Some observers had argued that Uber's greatest problem was not any of its scandals, but its CEO Travis Kalanick. Now that Kalanick no longer serves that role, is Uber off?
