Strategic Management Ch 10 essay
135. What is corporate governance and how is it used to monitor and control managers' decisions?
Corporate governance is the relationship among stakeholders that is used to determine and control the firm's strategic direction and its performance. Effective governance that aligns top-level managers' interests with shareholders' interests can produce a competitive advantage for the firm. Corporate governance includes oversight in areas where there are conflicts of interest among major stakeholders, including the election of directors, supervision of CEO pay, and the organization's overall structure and strategic direction. Three internal governance mechanisms (ownership concentration, the board of directors, and executive compensation) and an external mechanism (the market for corporate control) are used in U.S. corporations. Unfortunately, corporate governance mechanisms are not always successful.
141. Briefly compare and contrast corporate governance in the United States, Germany, and Japan, and China.
Corporate governance structures used in Germany and Japan differ from each other and from the ones used in the United States. Historically, the U.S. governance structure has focused on maximizing shareholder value. Banks have been at the center of the German corporate governance structure, because as lenders, banks become major shareholders in the firms. Shareholders usually allow the banks to vote their ownership positions, so banks have majority positions in many German firms. The German system has other unique features. For example, German firms with more than 2,000 employees are required to have a two-tier board structure, separating the board's management supervision function from other duties that it would normally perform in the United States (e.g., nominating new board members). Historically, German executives have not been dedicated to the maximization of shareholder value, because private shareholders rarely have major ownership in German firms, nor do larger institutional investors play a significant role. Attitudes toward corporate governance in Japan are affected by the concepts of obligation, family, and consensus. Japan continues to follow a bank-based financial and corporate governance structure compared to the market-based financial and corporate governance structure in the United States. In addition, Japanese firms belong to keiretsu, groups of firms tied together by cross-shareholding. In many cases, the main-bank relationship of the firm is part of a keiretsu. However, the influence of banks in monitoring and controlling managerial behavior and firm outcomes is beginning to lessen and a minor market for corporate control is emerging. Chinese corporate governance has become stronger in recent years. There has been a decline in equity held in state-owned enterprises, but the state still dominates the strategies employed by most firms. Firms with higher state ownership tend to have lower market value and more volatility in those values over time. In a broad sense, the Chinese governance system has been moving toward the Western model in recent years. For example, YCT International recently announced that it was strengthening its corporate governance with the establishment of an audit committee within its board of directors, and appointing three new independent directors. In addition, recent research shows that the compensation of top executives in Chinese companies is closely related to prior and current financial performance of the firm.
139. Discuss the difficulties in establishing performance-based compensation plans for executives.
Executive compensation, especially long-term incentive compensation, is complicated. First, the strategic decisions made by top-level managers are typically complex and nonroutine; as such, direct supervision of executives is inappropriate for judging the quality of their decisions. Because of this, there is a tendency to link the compensation of top-level managers to measurable outcomes such as financial performance. Second, an executive's decision often affects a firm's financial outcomes over an extended period of time, making it difficult to assess the effect of current decisions on the corporation's performance. In fact, strategic decisions are more likely to have long-term, rather than short-term, effects on a company's strategic outcomes. Third, a number of other factors affect firm performance. Unpredictable economic, social, or legal changes make it difficult to discern the effects of strategic decisions. Thus, although performance-based compensation may provide incentives to managers to make decisions that best serve shareholders' interests, such compensation plans alone are imperfect in their ability to monitor and control managers. Although incentive compensation plans may increase firm value in line with shareholder expectations, they are subject to managerial manipulation. For instance, annual bonuses may provide incentives to pursue short-run objectives at the expense of the firm's long-term interests. Supporting this conclusion, some research has found that bonuses based on annual performance were negatively related to investments in R&D, which may affect the firm's long-term strategic competitiveness. Although long-term performance-based incentives may reduce the temptation to underinvest in the short run, they increase executive exposure to risks associated with uncontrollable events, such as market fluctuations and industry decline. Long-term incentives may not be highly valued by a manager: thus, firms may have to overcompensate managers when they use long-term incentives.
142. How does corporate governance foster ethical strategic decisions and how important is this to top-level executives?
Governance mechanisms focus on the control of managerial decisions to ensure that the interest of shareholders, the most important stakeholder, will be served. But shareholders are just one stakeholder along with product market stakeholders (e.g., customers, suppliers, and host communities) and organizational stakeholders (e.g., managerial and nonmanagerial employees). These stakeholders are important as well. Therefore, at least the minimal interests or needs of all stakeholders must be satisfied through the firm's actions. Otherwise, dissatisfied stakeholders will withdraw their support from one firm and provide it to another (e.g., employees will exit and seek another employer, customers seek other vendors, etc.). Some believe that ethically responsible companies design and use governance mechanisms to ensure that the interests of all stakeholders are served. Top-level executives are monitored by the board of directors. All corporate stakeholders are vulnerable to unethical behaviors by the firm. If the image of the firm is tarnished, the image of customers, suppliers, shareholders, and board members is also tarnished. Top-level managers, as the agents who have been hired to make decisions that are in shareholders' best interests, are ultimately responsible for the development and support of an organizational culture that allows unethical decisions and behaviors. The board of directors has the power and responsibility to enforce this expectation. The decisions and actions of a corporation's board of directors can be an effective deterrent to unethical behaviors. The board has the power to hold top managers accountable for unethical actions as they can hire and fire these managers. Thus, the board of directors, which holds a position above the firm's highest-level managers, holds considerable power over top-level executives and can set and enforce standards for ethical behaviors within the organization.
136. Discuss the effect of the separation of ownership and control in the modern corporation.
Ownership is typically separated from control in the large U.S. corporation. Owners (principals) hire managers (agents) to make decisions that maximize the value of their firm. As risk specialists, owners diversify their risk by investing in an array of corporations. As decision-making specialists, top executives are expected by owners to make decisions that will result in earning above-average returns for which they are compensated. Thus, the typical corporation is characterized by an agency relationship that is created when one party (the firm's owners) hires and pays another party (top executives) to use decision-making skills. Since owners may not possess the specialized skill to run a large company, delegating these tasks to managers should produce higher returns for owners.
140. Describe the market for corporate control and its implications for organizations.
The market for corporate control is composed of individuals and firms who buy ownership positions in (e.g., take over) potentially undervalued firms to form a new division in an established firm or to merge the two previously separate firms. The target firm's top management team is usually replaced because it is assumed to be partly responsible for formulating and implementing the strategy that led to poor firm performance. The market for corporate control is (supposedly) triggered by low corporate performance by a firm relative to competitors in its industry. Thus, the market for corporate control should act as a control mechanism for corporate governance that leads to the replacement of under-performing executives. But, the market for corporate control is not an efficient governance mechanism because in reality many of the firms taken over have above-average performance. Hostile takeovers, on the other hand, are typically triggered by poor performance. Some managers have sought to buffer themselves from the effect of the market for corporate control (hostile takeovers) by instituting golden parachutes that will pay the managers significant extra compensation if the firm is taken over. Those and other takeover defenses are intended to increase the costs of mounting a takeover and reducing the managers' risk of losing their jobs. Examples of takeover defenses include asset restructuring, changes in the financial structure of the firm, reincorporation in another state, and greenmail. These defense tactics are controversial and the research on their effectiveness is inconclusive. Most institutional investors oppose them.
137. Define the agency relationship and managerial opportunism and discuss their strategic implications.
The separation of owners and managers creates an agency relationship. An agency relationship exists when a principal hires an agent as a decision-making specialist to perform a service. Some problems that result from the agency relationship between owners and managers include the potential for a divergence of interests and a lack of direct control of the firm by shareholders. Managerial opportunism is the seeking of self-interest with guile. It is both an attitude and a set of behaviors, which cannot be perfectly predicted from the agent's reputation. Top executives may make strategic decisions that maximize their personal welfare and minimize their personal risk, such as excessive product diversification. Decisions such as these prevent the maximization of shareholder wealth, which is supposed to be the top executives' priority. Although shareholders implement corporate governance mechanisms to protect themselves from managerial opportunism, these mechanisms are imperfect. Agency costs include the costs of managerial incentives, monitoring costs, enforcement costs, and the individual financial losses incurred by principals (owners of the firm) because governance mechanisms cannot guarantee total compliance by the agents (managers).
138. Define the three internal corporate governance mechanisms and how they may be used to control and monitor managerial decisions.
The three internal corporate governance mechanisms are: ownership concentration, the board of directors, and executive compensation. Ownership concentration is based on the number of large-block shareholders and the percentage of shares they own. With significant ownership percentage, institutional investors, such as mutual funds and pension funds, are often able to influence top executives' strategic decisions and actions. Thus, unlike diffuse ownership, which tends to result in relatively weak monitoring and control of managerial decisions, concentrated ownership produces more active and effective monitoring of top executives. An increasingly powerful force in corporate America, institutional owners are actively using their positions of concentrated ownership in individual companies to force managers and boards of directors to make decisions that maximize a firm's value. These owners (e.g., CalPERS) have caused poorly performing CEOs to be ousted from the firm. The board of directors, elected by shareholders, is composed of insiders, related outsiders, and outsiders. The board of directors is a governance mechanism shareholders expect to run the firm in such a ways as to maximize shareholder wealth. Outside directors are expected to be more independent of a firm's top executives than are those who hold top management positions within the firm. A board with a significant percentage of insiders tends to be weak in monitoring and controlling management decisions. Boards of directors have been criticized for being ineffective, and there is a movement to more formally evaluate the performance of boards and their individual members. Executive compensation is a highly visible and often criticized governance mechanism. Salary, bonuses, and long-term incentives such as stock options are intended to reward top executives for aligning their goals with the interests of shareholders. A firm's board of directors has the responsibility of determining the degree to which executive compensation succeeds in controlling managerial behavior. But, it is difficult to evaluate top executives' performance, and so executive compensation tends to be linked to financial measures which do not necessarily reflect the effectiveness of the executive's decision on long-term shareholder outcomes. In addition, many external factors affect the performance of a firm. Moreover, performance incentive plans can be subject to management manipulation. Consequently, executive compensation is a far-from-perfect governance mechanism.