Chapter 11: Corporate Performance, Governance and Business Ethics

Agency Theory

-A. Agency theory looks at the problems that can arise in a business relationship when one person delegates decision making authority to another. It offers a way to understand why managers do not always act in the best interests of stakeholders. -B. An agency relationship occurs whenever one person delegates decision-making authority to another. The principal is the person delegating authority, and the agent is the person to whom the authority is delegated. -C. The agency problem is that principals and agents may have different goals, and therefore, that agents may act in ways that are not in the best interests of their principals. --1. Agents may do this because of information asymmetry—that is, because the agent almost always has more information about the resources they are managing than does the principal. --2. Thus, it is difficult for the principals to measure the agent's performance or to hold them accountable for their performance. --3. To some extent, it's impossible for a principal to know for sure whether the agent is acting in the principal's best interests, and so the principal must trust the agent. --4. The principals also make efforts to monitor agents, evaluate their performance, and, if necessary, take corrective actions.

The Agency Problem

-Agents and principles may have different goals -Agents may pursue goals that are not in the best interests of their principles -Agents may take advantage of information asymmetries to maximize their interests at the expense of principals -It is difficult for principals to measure performance -Trust -On-the-job consumption -Empire building

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An ethical strategy is one that does not violate commonly accepted principles

Do not realize they are behaving unethically

By failing to ask the right questions

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Companies that neglect to satisfy the needs of one or more important stakeholder groups will find that the stakeholders withdraw their support, damaging the firm

The challenge for Principals

Confronted with agency problems, the challenge for principals is to: 1) Shape the behavior of agents so that they act in accordance with goals set by principals 2) Reduce information asymmetry between agents and principals 3) Develop mechanisms for removing agents who do not act in accordance with goals and principals

Contract Law

Contracts and breaches of contracts

External Stakeholders

Customers Suppliers Creditors Governments at all levels Unions Local communities General Public

Internal Stakeholders

Employees Stockholders

Unrealistic Performance goals

Encouraging and legitimizing unethical behavior

Justice Theories

Focus on the attainment of a just distribution of economic goods and services that is considered to be fair and equitable.

Behaving ethically

Goes beyond staying within the law

Antitrust law

Governing competitive behavior

Tort Laws

Governing product liability

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Governments expect every company to make profits only within the limits set by the law The general public expects companies to profit in a manner consistent with social expectations Every stakeholder group disapproves of the unfettered pursuit of profit if it leads to unethical or illegal behavior

Stakeholders

In a reciprocal relationship with the firm, providing organization with resources and expecting some benefit in return

Corporate raiders

Individuals or corporations that buy up large blocks of shares in companies that they think are pursing strategies that do not maximize wealth _intend to run the company

Securities law

Issuing and selling securities

Profitability, Profit Growth, and Stakeholder Claims

Managers can best serve the interests of stockholders (the most important group of stakeholders) by increasing profitability Increasing profitability that can be measured by ROIC tends to both increase the funds available for dividends and drive up the value of the stock

The Friedman Doctrine

Milton Friedman's basic position is that the only social responsibility of business is to increase profits, as long as the company stays within the law and the rules of the game without deception or fraud.

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Principals try to deal with these challenges through a series of governance mechanisms

Rights Theory

Recognizes that human beings have fundamental rights and privileges. Rights establish a minimum level of morally acceptable behavior.

Governance Mechanisms

Serve to limit the agency problem by aligning incentives between agents and principals and by monitoring and controlling agents

The Unique Role of Stockholders Supplement

Stockholder's position in unique because the stockholders are the legal owners of the firm as well as the providers of funds

Governance Mechanisms Inside a Company Internal agency problems can be reduced by:

Strategic control systems Employee Incentives

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The agency problem also exists in the relationship between higher-level managers and their lower-level subordinates. For example, a subordinate may withhold information to increase his pay or job security or get more than his unit's fair share of organizational resources.

Utilitarian and Kantian Ethics

The moral worth of actions is determined by its consequences - leading to the best possible balance of good versus bad consequences. Committed to the maximization of good and the minimization of harm.

The Tradeoff Between Probability and Revenue Growth Rates

Too much growth too quickly also leads organizations to pay too much for acquisition targets, further depressing profits

Personal ethics code

Will have a profound influence on behavior as a businessperson

Anti Competitive behavior

covers the range of actions aimed at harming actual or potential competitors, often through the use of monopoly power.

Responsiveness to Customers

customers include the number of repeat customers, on-time delivery rates, and level of customer service.

Strike Price

d) In recent years, boards of directors have been playing a more active role in corporate governance. (1) One reason for the enhanced oversight is the lawsuits that stockholders have filed against board members. In some cases, board members must pay damages out of their own pocket. Another governance is stock-based compensation for principals. If agents are working under a pay-for-performance system, then it will be in their best interests to increase profitability. a) The most common pay-for-performance system grants stock options to managers, which gives them the right to buy shares at a predetermined price (called the strike price) at some point in the future. Typically, the strike price is the trading price at the time the option was granted. b) However, when CEOs exercise their options several years later, their compensation increases dramatically. Some claim that stock options are too generous, especially when the strike price is set deliberately low. c) Another criticism of stock options is that issuing more shares of stock dilutes the equity of the existing stockholders. Some critics would like options to be shown on financial statements as an expense, but at this time, companies are not required to do so, although some do so voluntarily.

The Roots of Unethical Behavior include

faulty personal ethics, a focus on business dimension of a decision to the exclusion of other considerations, an organizational culture that de-emphasizes business ethics, an environment that pressures managers with unrealistic performance goals, and leadership or the lack thereof.

Efficiency

include production costs, raw materials costs, and number of labor hours needed to make a product

Innovation

number of new products introduced, the time taken to develop a product, and the revenues generated from new products.

Corruption

occurs when managers pay bribes to gain access to lucrative business contracts.

Inside directors

senior employees of the firm and are charged with bringing information about the company to the board. However, they are employees and their interests tend to be aligned with management.

Ethical Issues in Strategy Self-Dealing

when managers misappropriate corporate monies for their own purposes.

Stockholders receive their returns as:

-Dividend payments -Capital appreciation in market value of shares

Employee Incentives

-Employee stock options and stock ownership plans -Compensation tied to attainment of superior efficiency, quality, innovation, and responsiveness to customers

Stakeholder Impact Analysis

-Identify stakeholders -Identify stakeholders' interests and concerns -Identify what claims stakeholders are likely to make on the organization -Identify stakeholders who are most important from the organization's perspective -Identify resulting strategic challenges

Ethical Issues in Strategy

-Self-dealing -Information manipulation -Anticompetitive behavior -Opportunistic exploitation -Substandard working conditions -Environmental degradation -Corruption

Not all stakeholders are satisfied with high profitability

-Suppliers want to sell to a profitable company because it will pay for what it receives. -Customers want to buy from a profitable company that will exist long enough to provide customer service and additional sales However, neither group wants the firm to profit at their experts

Ethical dilemmas occur when:

-There is no agreement over what the accepted principles are -None of the available alternatives seem ethically acceptable

Strategic Control Systems

-To establish standards against which performance can be measured -To create systems for measuring and monitoring performance -To compare actual performance against targets -To evaluate results and take corrective actions --> Balanced scorecard model approach is used to drive future performance

Learning Objectives

-Understand relationship between stakeholder management & corporate performance -Explain why maximizing returns to stockholders often viewed as primary goal -Describe governance mechanisms to align interest of stockholders & management -Explain why governance methods don't always work -Identify ethical issues that arise in business & causes of unethical behavior -Identify what managers do to improve the ethical climate and ensure decisions don't violate ethical principles

Behaving Ethically To make sure that ethical issues are considered in business decisions, managers should:

1) Favor hiring and promoting people with a well-grounded sense of personal ethics. 2) Build an organizational culture that places a high value on ethical behavior. 3) Make sure that leaders not only articulate but also act in an ethical manner. 4) Put decision-making processes in place that require people to consider the ethical dimension of business decisions. 5)Use ethics officers. 6) Put strong corporate governance processes in place. 7) Act with moral courage and encourage others to do the same.

Boards of Directors are charged with several responsibilities

1) Legally responsibility for the firm's actions and act to oversee the actions of the firm's CEO and top managers (2) The board makes decisions about hiring, firing, and compensating top corporate executives. (3) The board ensures that the audited financial statement, which is the primary reporting tool from managers to stockholders, presents a true picture of the organization's health. b) Boards of directors are typically composed of a mix of corporate insiders and outsiders.

To grow more profits, companies must be doing one or more of the following:

1) Participating in a market that is growing 2) Taking market share away from competitors 3) Consolidating the industry via horizontal integration 4) Developing new markets

The Roots of Unethical Behavior Why do some managers behave unethically? No simple answers, but some generalizations:

1) Personal ethics code 2) Do not realize they are behaving unethically 3) Organization's culture 4) Unrealistic performance goals 5) Unethical leadership

CEO

2. Boards of directors typically make executive pay decisions in order to control expenses. However, CEOs can use their influence with the board to get pay increases. The historically high level of CEO pay in the U.S. can be attributed to this cause. a) CEO pay is rapidly increasing and is at the highest level it has ever been. b) CEO pay is rising more rapidly than workers' pay. In 1980, the average CEO earned 42 times what the average worker did; by 1990, CEO pay was 400 times greater. c) CEO compensation is increasing, including stock options or other forms of indirect payment. For most CEOs, stock options are a far bigger part of their total compensation than is their base salary. d) CEO compensation doesn't seem to be linked to corporate profitability; many CEOs of companies that posted an overall financial loss received large increases in pay for that same period.

Stakeholder Impact Analysis Supplement

A company cannot fully satisfy all of its stakeholders at the same time

The Unique Role of Stockholders

A company's legal owners and the provider of risk capital, a major source of capital to operate a business Maximizing long-run profitability & profit growth is the route to maximizing returns to shareholders, as well as satisfying the claims of most other stakeholder groups

Each stakeholder group has a unique relationship with the firm

A. Stockholders provide funds and expect returns B. Creditors provide funds and expect repayment and interest C. Employees provide labor, skills and ideas and expect income, job satisfaction and security and good working conditions D. Customers provide sales revenues and expect products that provide value for money E. Suppliers provide inputs and expect revenues and dependable buyers F. Governments provide regulation and expect companies to adhere to the rules G. Unions provide productive employees and expect income and other benefits for their members H. Local communities provide local infrastructure and expect companies to behave as responsible citizens I. The general public provides national infrastructure and expects the company to improve their quality of life

Agency Theory Agency Relationships

Arise whenever one party delegates decision-making authority or control over resources to another

Three most important stakeholder group

Customers Employees Stockholders

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D. The agency problem exists in corporations, as stockholders (the principals) are the company's owners, but they delegate decision-making power to the company's managers (the agents).

Organization's culture

De-emphasizes ethics and considers primarily economic consequences

Risk Capital

Money provided by stockholders -Stockholders are making a risky investment in the firm with no guarantee of returns or even the preservation of their original investment -Obliged to reward stockholders by pursuing strategies that maximize returns on them -When employees become stockholders too, through employee stock ownership plans (ESOPs), the importance of maximizing stockholder return grows

Greenmail

Even if raiders do not succeed in the takeover, the defending company will often but back their shares just to be ride of them, paying a premium price

The Tradeoff Between Profitability and Revenue Growth Rates

Graph on Notecard Need to maximize long-run shareholder returns by seeking the right balance between company growth and profitability and profit growth

Stakeholders

Individuals or groups with an interest, claim or stake in the company, in what it does, and in how well it performs Internal Stakeholders External Stakeholders A company must consider stakeholder claims in developing and implementing strategy

On the Job Consumption

Managers, like other people, desire status, power, job security, and income. They can use their decision-making authority and control over corporate funds to satisfy those desires at the expense of stockholders.

A Balanced Scorecard Approach

Notecard

Outside Directors

Outside directors are not full-time corporate employees, and they are charged with bringing objectivity to the board. Full-time professional directors hold positions on several boards and do a good job because their professional reputations are at stake.

Philosophical Approaches to Ethics

Philosophical underpinnings of business ethics that can provide managers with a moral compass to help navigate through difficult ethical issues: -The Friedman Doctrine -Utilitarian and Kantian Ethics -Rights Theories -Justice Theories

Principal Agent Relationships

Principal: person delegating authority Agent: person to whom authority is delegated

Intellectual Property Law

Protection of intellectual property

Takeover Constraint

Stockholders decide to sell the stock, causing the value of the shares to decline below the book value of its assets An acquire could then purchase the firm, sell the assets and profit

Unethical leadership

That encourages and tolerate behavior that is ethically suspect

These mechanisms include:

The Board of Directors Stock-Based Compensation Financial Statements The Takeover Constraint

Ethics and Strategy Business Ethics

The accepted principles of right or wrong governing the conduct of businesspeople

The Balanced Scorecard Approach

The balanced scorecard approach to strategic control asks top managers to evaluate performance on efficiency, quality, innovation, and responsiveness to customers, in addition to the financial information used in traditional strategic control systems. The additional information focuses on future performance, whereas financial information relates to decisions and actions that were made or taken in the past.

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The firm buss be profitable then it can satisfy their stakeholders Satisfies employees, creditors, local communities

Empire Building

To increase, power, status and income a CEO might buy many new businesses to increase the size of the firm through diversification Diversifying without an appropriate reason to do so, reduces profitability, because funds are not used to pay the debt incurred to finance growth

Many accepted principles are codified into laws:

Tort Laws Contract laws Intellectual property law Antitrust law Securities law Behaving ethically

Governance Mechanisms

US and UK firms tend to rely heavily upon corporate boards of directors, elected by stockholders, to represent the interests of the stockholders

Strategic Control Systems

a) Strategic control mechanisms are the primary mechanism of internal governance. These systems consist of the formal goal setting, measurement, and feedback systems that allow managers to evaluate the effectiveness of their firm's strategy. b) The process requires top managers to establish standards, create a system for periodic measurement, compare actual performance to the standards, and evaluate results. c) These steps ensure that lower-level managers, as the agent of top managers, are acting in the best interests of top managers.

Substandard working conditions

arise when managers underinvest in working conditions or pay employees less than market rates.

Criticism of Boards

c) Many boards perform admirably, but some, such as that of Enron, do not. (1) One criticism of boards of directors is that insiders often dominate them and therefore can manipulate perceptions. (2) Another criticism of boards is that many are dominated by the CEO, particularly when the CEO is also chairman of the board. When this occurs, the CEO may choose both the inside and the outside directors, who may feel loyalty to the CEO or allow the CEO to control the agenda.

Opportunistic exploitation

occurs when managers seek to unilaterally rewrite the terms of a contract in ways that are more favorable to their own firm.

Environmental degradation

occurs when the firm takes actions that directly or indirectly result in pollution or other forms of environmental harm.

Quality

the reject rate, the rate of returns of defective items from customers, and the product reliability over time

Information Manipulation

when managers use their control over corporate data to enhance their own financial situation or the competitive position of the firm.