Strategic Management Ch. 10

demand for greater accountability and improved performance is stimulating many boards to voluntarily make changes such as:

(1) increases in the diversity of the backgrounds of board members (e.g., a greater number of directors from public service, academic, and scientific settings; a greater percentage of ethnic minorities and women; and members from different countries on boards of U.S. firms); (2) the strengthening of internal management and accounting control systems; (3) establishing and consistently using formal processes to evaluate the board's performance; (4) modifying the compensation of directors, especially reducing or eliminating stock options as a part of their package; (5) creating the "lead director" role that has strong powers with regard to the board agenda and oversight of non-management board member activities.

three internal governance mechanisms

(1) ownership concentration, represented by types of shareholders and their different incentives to monitor managers; (2) the board of directors; (3) executive compensation. We then consider the market for corporate control, an external corporate governance mechanism. Essentially, this market is a set of potential owners seeking to acquire undervalued firms and earn above average returns on their investments by replacing ineffective top-level management teams

Two benefits of additional diversification

1) Product diversification usually increases the size of a firm and that size is positively related to executive compensation. Diversification also increases the complexity of managing a firm and its network of businesses, possibly requiring additional managerial pay because of this complexity. Thus, increased product diversification provides an opportunity for top-level managers to increase their compensation. 2) product diversification and the resulting diversification of the firm's portfolio of businesses can reduce top-level managers' employment risk. Managerial employment risk is the risk of job loss, loss of compensation, and loss of managerial reputation. These risks are reduced with increased diversification, because a firm and its upper-level managers are less vulnerable to the reduction in demand associated with a single or limited number of product lines or businesses. Events that occurred at Lockheed demonstrate these issues. Lockheed receives 82% of revenue from the government - when govt tries reducing costs it could cause their revenue to go down by over 50% which means that diversifying themselves would be extremely useful. It is very risky to have one main source of revenue.

internal governance mechanism, executive compensation—especially long-term incentive compensation—is complicated, for several reasons:

1) direct supervision (even by the firm's board of directors) is likely to be ineffective as a means of judging the quality of their decisions. The result is a tendency to link top-level managers' compensation to outcomes the board can easily evaluate, such as the firm's financial performance. 2) typically, the effects of top-level managers' decisions are stronger on the firm's long-term performance than its short-term performance. This reality makes it difficult to assess the effects of their decisions on a regular basis (e.g., annually). 3) a number of other factors affect a firm's performance besides top-level managerial decisions and behavior. Unpredictable changes in segments (economic, demographic, political/ legal, etc.) in the firm's general environment (see Chapter 2) make it difficult to separate out the effects of top-level managers' decisions and the effects (both positive and negative) of changes in the firm's external environment on the firm's performance.

Why separation of ownership?

In family-owned firms there is little, if any, separation between ownership and control. "the managerial revolution led to a separation of ownership and control in most large corporations, where control of the firm shifted from entrepreneurs to professional managers while ownership became dispersed among thousands of unorganized stockholders who were removed from the day-to-day management of the firm." These changes created the modern public corporation, which is based on the efficient separation of ownership and managerial control. Supporting the separation is a basic legal premise suggesting that the primary objective of a firm's activities is to increase the corporation's profit and, thereby, the owners' (shareholders') financial gains. Without owner (shareholder) specialization in risk bearing and management specialization in decision making, a firm may be limited by its owners' abilities to simultaneously manage it and make effective strategic decisions relative to risk. Thus, the separation and specialization of ownership (risk bearing) and managerial control (decision making) should produce the highest returns for the firm's owners

For 2013, this group's "Best Corporate Governance Awards" by country were given to

Royal Bank of Canada (Canada), COSCO (China), Continental AG (Germany), Royal Philips Electronics (Netherlands), GlaxoSmithKline (United Kingdom), and AECOM (United States). These awards are determined by analyzing a number of issues concerned with corporate governance, such as board accountability and financial disclosure, executive compensation, shareholder rights, ownership base, takeover provisions, corporate behavior, and overall responsibility exhibited by the company

CHINA

There has been a gradual decline in the equity held in state-owned enterprises and the number and percentage of private firms have grown, but the state still relies on direct and/or indirect controls to influence the strategies firms use. Even private firms try to develop political ties with the government because of their role in providing access to resources and to the economy. In long-term success, these conditions may affect firms' performance as research shows that firms with higher state ownership tend to have lower market value and more volatility in that value across time. Due to agency conflicts in the firms and because the executives do not seek to maximize shareholder returns given that they must also seek to satisfy social goals placed on them by the government. This suggests a potential conflict between the principals, particularly the state owner and the private equity owners of the state owned enterprises. Some evidence suggests that corporate governance there may be tilting toward the Western model. For example, recent research shows that with increasing frequency, the compensation of top-level executives in Chinese companies is closely related to prior and current financial performance of their firm. Research also shows that due to the weaker institutions, firms with family CEOs experience more positive financial performance than others without the family influence. Changing a nation's governance systems is a complicated task that will encounter problems as well as successes while seeking progress. Thus, corporate governance in Chinese companies continues to evolve and likely will for some time to come as parties (e.g., the Chinese government and those seeking further movement toward free market economies) interact to form governance mechanisms that are best for their nation, business firms, and citizens. However, along with changes in the governance systems of specific countries, multinational companies' boards and managers are also evolving. For example, firms that have entered more international markets are likely to have more top executives with greater international experience and to have a larger proportion of foreign directors on theory boards.

Large-block shareholders

Typically own at least 5 percent of a company's issued shares.

board of directors

a group of elected individuals whose primary responsibility is to act in the owners' best interests by formally monitoring and controlling the firm's top-level managers. The Board of Directors is an important internal governance mechanism. It is widely believed that increased director independence and board member diversity lead to more effective governance.

publicly traded German corporations,

a single shareholder is often dominant. Thus, the concentration of ownership is an important means of corporate governance in Germany, as it is in the United States Historically, banks occupied the center of the German corporate governance system. This is the case in other European countries as well, such as Italy and France. As lenders, banks become major shareholders when companies they financed seek funding on the stock market or default on loans. Although the stakes are usually less than 10 percent, banks can hold a single ownership position up to but not exceeding 15 percent of the bank's capital. Although shareholders can tell banks how to vote their ownership position, they generally do not do so. The banks monitor and control managers, both as lenders and as shareholders, by electing representatives to supervisory boards.

German firms with more than 2,000 employees are required

a two-tiered board structure placing responsibility for monitoring and controlling managerial decisions and actions in the hands of a separate group. All the functions of strategy and management are the responsibility of the management board (the Vorstand); however, appointment to the Vorstand is the responsibility of the supervisory tier (the Aufsichtsrat). Employees, union members, and shareholders appoint members to the Aufsichtsrat. They do this as they think it helps prevent corporate wrongdoing and rash decisions by "dictatorial CEOs." However, critics maintain that it slows decision making and often ties a CEO's hands. The corporate governance practices make it difficult to restructure companies as quickly as can be done in the United States. Because of the role of local government (through the board structure) and the power of banks in Germany's corporate governance structure, private shareholders rarely have major ownership positions in German firms. Additionally, there is a significant amount of cross-shareholdings among firms. However, large institutional investors, such as pension funds (outside of banks and insurance companies), are also relatively insignificant owners of corporate stock. Thus, at least historically, German executives generally have not been dedicated to maximizing shareholder wealth to the degree that is the case for top-level managers in the United Kingdom and the United States NOW they are using more US governance mechanisms

The three internal and one external governance mechanisms are designed to ensure

agents of the firm's owners- the corporation's top-level managers—make strategic decisions that best serve the interests of all stakeholders. In the United States, shareholders are commonly recognized as the company's most significant stakeholders. Increasingly though, top-level managers are expected to lead their firms in ways that will also serve the needs of product market stakeholders (e.g., customers, suppliers, and host communities) and organizational stakeholders (e.g., managerial and nonmanagerial employees). Therefore, the firm's actions and the outcomes flowing from them should result in at least minimal satisfaction of the interests of all stakeholders. Without at least minimal satisfaction of its interests, a dissatisfied stakeholder will withdraw its support from the firm and provide it to another.

market for corporate control

an external governance mechanism that is active when a firm's internal governance mechanisms fail. It is composed of individuals and firms that buy ownership positions in or purchase all of potentially undervalued corporations typically for the purpose of forming new divisions in established companies or merging two previously separate firms. Because the top-level managers are assumed to be responsible for the undervalued firm's poor performance, they are usually replaced. An effective market for corporate control ensures that ineffective and/or opportunistic top-level managers are disciplined.

Pension funds

are critical drivers of growth and economic activity in the United States because they are one of the only significant sources of long-term, patient capital.

Institutional owners

are financial institutions such as mutual funds and pension funds that control largeblock shareholder positions.

evidence suggests that the most effective boards set

boundaries for their firms' business ethics and values. After the boundaries for ethical behavior are determined and likely formalized in a code of ethics, the board's ethics based expectations must be clearly communicated to the firm's top-level managers and to other stakeholders (e.g., customers and suppliers) with whom interactions are necessary for the firm to produce and sell its products. Moreover, as agents of the firm's owners, top-level managers must understand that the board, acting as an internal governance mechanism, will hold them fully accountable for developing and supporting an organizational culture in which only ethical behaviors are permitted. CEOs can be positive role models for improved ethical behavior.

a corporate-level strategy to diversify the firm's product lines

can enhance a firm's strategic competitiveness and increase its returns, both of which serve the interests of all stakeholders and certainly shareholders and top-level managers. However, product diversification can create two benefits for top-level managers that shareholders do not enjoy, meaning that they may prefer product diversification more than shareholders do

board members (often called directors)

classified into one of three groups Insiders: are active top-level managers in the company who are elected to the board because they are a source of information about the firm's day-to-day operations Related outsiders: have some relationship with the firm, contractual or otherwise, that may create questions about their independence, but these individuals are not involved with the corporation's day-to-day activities. Outsiders: provide independent counsel to the firm and may hold top-level managerial positions in other companies or may have been elected to the board prior to the beginning of the current CEO's tenure

Ownership concentration

defined by the number of large-block shareholders and the total percentage of the firm's shares they own.

Scandals at companies such as Enron, WorldCom, HealthSouth, and Satyam (a large information technology company based in India), among others,

illustrate the negative effects of poor ethical behavior on a firm's efforts to satisfy stakeholders. The issue of ethical behavior by top-level managers as a foundation for best serving stakeholders' interests is being taken seriously in countries throughout the word

Executive compensation

is a governance mechanism that seeks to align the interests of managers and owners through salaries, bonuses, and long-term incentives such as stock awards and options.

Corporate governance

is the set of mechanisms used to manage the relationships among stakeholders and to determine and control the strategic direction and performance of organizations. involves oversight in areas where owners, managers, and members of boards of directors may have conflicts of interest

Managerial opportunism

seeking of self-interest with guile (i.e., cunning or deceit). Opportunism is both an attitude (e.g., an inclination) and a set of behaviors (i.e., specific acts of self interest). Principals do not know beforehand which agents will or will not act opportunistically. A top-level manager's reputation is an imperfect predictor; Opportunistic behavior cannot be observed until it has occurred. Thus, principals establish governance and control mechanisms to prevent agents from acting opportunistically, even though only a few are likely to do so. Research suggests that when CEOs feel constrained by governance mechanisms, they are more likely to seek external advice that in turn helps them make better strategic decisions. The agency relationship suggests that any time principals delegate decision-making responsibilities to agents, the opportunity for conflicts of interest exists. Top-level managers, for example, may make strategic decisions that maximize their personal welfare and minimize their personal risk. Decisions such as these prevent maximizing shareholder wealth. Decisions regarding product diversification demonstrate this situation.

bribery

tends to limit entrepreneurial activity that can help a country's economy grow. While larger multinational firms tend to experience fewer negative outcomes, their power to exercise more ethical leadership allows them greater flexibility in selecting which markets they will enter and how they will do so

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.

agency relationship

when one party delegates decision-making responsibility to a second party for compensation