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CHAPTER 9

Strategic Control and Corporate Governance

Learning Objectives

After reading this chapter, you should have a good understanding of:

9-1 The value of effective strategic control systems in strategy implementation.

9-2 The key difference between “traditional” and “contemporary” control systems.

9-3 The imperative for contemporary control systems in today’s complex and rapidly changing competitive and general environments.

9-4 The benefits of having the proper balance among the three levers of behavioral control: culture, rewards and incentives, and boundaries.

9-5 The three key participants in corporate governance: shareholders, management (led by the CEO), and the board of directors.

9-6 The role of corporate governance mechanisms in ensuring that the interests of managers are aligned with those of shareholders from both the United States and international perspectives.

©McGraw-Hill Education.

Strategic Control

Consider . . .

Once strategy is formulated, it must be implemented, and part of implementation is establishing a mechanism for monitoring and correcting organizational performance.

This control mechanism must be consistent with the strategy the firm is following.

How does a firm make sure all key stakeholders are moving in the right direction?

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Organizations must have effective strategic controls, mechanisms for monitoring and correcting organizational performance if they are to successfully implement their strategies. Control systems must exercise both informational and behavioral control – employees and managers must know what the goals are, what the rules and procedures are, and what the rewards for performance will be. These controls must be consistent with the strategy that the firm is following. When individuals in the firm internalize goals and strategies, there is less need for monitoring behavior, and efforts are focused more on important organizational goals and objectives. In addition, a firm must promote sound corporate governance to ensure that the interests of managers and shareholders are aligned. As both general and competitive environments become more unpredictable and complex, the need for effective strategic control systems increases.

Strategic Control Mechanisms

Strategic control involves monitoring performance toward strategic goals and taking corrective action when needed via effective systems.

Informational-control systems

Behavioral-control systems

Corporate governance

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Strategic control = the process of monitoring and correcting a firm’s strategy and performance. An organization does a strategic analysis of the external environmental conditions, evaluates its internal capabilities for responding to those conditions, formulates a strategy for sustaining a competitive advantage, and then implements this strategy. Once implemented, this strategy must be monitored and adjusted as needed. Effective strategic control systems allow for corrective action to be taken. Informational control is the ability to respond effectively to environmental change, while behavioral control makes sure there is an appropriate balance and alignment among a firm’s culture, rewards, and boundaries. Corporate governance pays attention to the need for a firm’s shareholders (the owners) and their elected representatives (the board of directors) to ensure that the firm’s executives (the management team) strive to fulfill their fiduciary duty of maximizing long-term shareholder value. Poor governance and control can lead to damage of a firm’s reputation.

Strategic Control: Traditional Approach Model

The traditional approach to strategic control is sequential.

Strategies are formulated, goals are set.

Strategies are implemented.

Performance is measured against predetermined goals.

Exhibit 9.1 Traditional Approach to Strategic Control

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Traditional approach to strategic control = a sequential method of organizational control in which (1) strategies are formulated and top management sets goals, (2) strategies are implemented, and (3) performance is measured against the predetermined goal set.

Strategic Control: Traditional Approach

Traditional approach to strategic control = feedback loop from performance measurement to strategy formulation

Involves lengthy time lags, “single-loop” learning

Most appropriate when:

Environment is stable and relatively simple.

Objectives can be measured with certainty.

There is little need for complex measures of performance.

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The traditional approach to strategic control is based on a feedback loop from performance measurement to strategy formulation. This process typically involves lengthy time lags, often tied to a firm’s annual planning cycle. Such traditional control systems, termed “single–loop” learning by Harvard’s Chris Argyris, simply compare actual performance to a predetermined goal. They are most appropriate when the environment is stable and relatively simple, goals and objectives can be measured with a high level of certainty, and there is little need for complex measures of performance. Sales quotas, operating budgets, production schedules, and similar quantitative control mechanisms are typical. The appropriateness of the business strategy or standards of performance is seldom questioned. This traditional approach does not work well for firms competing in highly unpredictable competitive environments. Sometimes strategies need to change frequently and opportunistically. An inflexible commitment to predetermined goals and milestones can prevent the very adaptability that is required of a good strategy.

Strategic Control: Contemporary Approach Model

Relationships between strategy formulation, implementation, & control are highly interactive, utilizing:

Informational control

Behavioral control

Exhibit 9.2 Contemporary Approach to Strategic Control

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The contemporary approach to strategic controls allows managers to adapt to and anticipate changes in both the internal and external environment. The relationships between strategy formulation, implementation, and control are highly interactive. This approach utilizes two different types of strategic control: informational control and behavioral control. Informational control = a method of organizational control in which a firm gathers and analyzes information from the internal and external environment in order to obtain the best fit between the organization’s goals and strategies and the strategic environment. Behavioral control = a method of organizational control in which a firm influences the actions of employees through culture, rewards, and boundaries.

Strategic Control: Contemporary Approach

Informational control = Is the organization “doing the right things”?

Behavioral control = Is the organization “doing things right” in the implementation of its strategy?

Both types of control are necessary, but not sufficient, conditions for success.

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Informational control is primarily concerned with whether or not the organization is obtaining the best fit between its goals and strategies and the external strategic environment: Is the organization “doing the right things,” given the external situation and the internal capabilities of the organization? Behavioral control, on the other hand, is a mechanism for making sure the employees of the firm are doing things correctly while implementing strategy: Are the employees “doing things right”? Both the informational and behavioral components of strategic control are necessary, but not sufficient, conditions for success. What good is a well-conceived strategy that cannot be implemented? Or what use is an energetic and committed workforce if it is focused on the wrong strategic target?

Strategic Control: Contemporary Approach Effectiveness

Contemporary control systems using informational control are effective when:

Focus is on constantly changing information that has potential strategic importance.

Information is important enough to demand frequent & regular attention from all levels.

Data & information are interpreted & discussed in face-to-face meetings.

Control system is a catalyst for ongoing debate about underlying data, assumptions & plans.

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Contemporary control systems must have four characteristics to be effective. 1. The focus is on constantly changing information that has potential strategic importance. 2. The information is important enough to demand frequent and regular attention from all levels of the organization. 3. The data and information generated are best interpreted and discussed in face-to-face meetings. 4. The control system is a key catalyst for an ongoing debate about underlying data, assumptions, and action plans. An executive’s decision to use the control system interactively—in other words, to invest the time and attention to review and evaluate new information—sends a clear signal to the organization about what is important. The dialogue and debate that emerge from such an interactive process can often lead to new strategies and innovations.

Question (1 of 3)

Top managers at ABC Company meet every Friday to review daily operational reports and year-to-date data. This is an example of

behavioral control.

informational control.

strategy formulation.

strategy implementation.

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Answer: B. The information reviewed will be used to assess the effectiveness of the strategy’s implementation. This is a key role of informational control.

Informational Control: Issues

Informational control deals with both the internal & external environment.

Do the organization’s goals and strategies still “fit” within the context of the current strategic environment?

Two key issues:

Scan & monitor the external environment

Continuously monitor the internal environment

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Remember, informational control is primarily concerned with whether or not the organization is obtaining the best fit between its goals and strategies and the external strategic environment: Is the organization “doing the right things,” given the external situation and the internal capabilities of the organization? Informational control addresses the assumptions and premises that provide the foundation for an organization’s strategy and, depending on the type of business, such assumptions may relate to changes in technology, customer tastes, government regulation, and industry competition. Therefore, managers must scan and monitor the external environment, both the general environment and the industry environment. In addition, conditions can change in the internal environment of the firm, requiring changes in the strategic direction of the firm. Changing internal conditions can include the resignation of key executives or delays in the completion of major production facilities.

Informational Control: Characteristics

Informational control = ongoing process of organizational learning

Focus is on constantly changing information – continuous monitoring, testing, review.

Data is interpreted and discussed face-to-face.

Ongoing debates challenge assumptions.

Time lags are shortened.

Changes are detected earlier.

Speed & flexibility of response is enhanced.

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In the contemporary approach, information control is part of an ongoing process of organizational learning that continuously updates and challenges the assumptions that underlie the organization’s strategy. In such “double-loop” learning, the organization’s assumptions, premises, goals, and strategies are continuously monitored, tested, and reviewed. The benefits of continuous monitoring are evident – time lags are dramatically shortened, changes in the competitive environment are detected earlier, and the organization’s ability to respond with speed and flexibility is enhanced.

Question (2 of 3)

Which of the following is not one of the characteristics of a contemporary control system?

It is a key catalyst for an ongoing debate about underlying data, assumptions, and action plans.

It must focus on constantly changing information that is strategically important.

It circumvents the need for face-to-face meetings among superiors, subordinates, and peers.

It generates information that is important enough to demand regular and frequent attention.

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Answer: C. One of the key components of a contemporary control system is the ongoing feedback loop between strategic formulation and strategic implementation: the ongoing debate about the underlying data and assumptions about strategic action given current information. This feedback loop requires a significant degree of communication between superiors, subordinates, and peers.

Behavioral Control Model

Behavioral control = focused on implementation – “doing things right”

Influences the actions of employees via:

Culture

Rewards

Boundaries

Exhibit 9.3 Essential Elements of Behavioral Control

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Remember, behavioral control is a mechanism for making sure the employees of the firm are doing things correctly while implementing strategy, allowing managers to see if the employees are “doing things right.” Behavioral control is a method of organizational control in which a firm influences the actions of employees through culture, rewards, and boundaries. There are two compelling reasons for increased emphasis on culture and rewards in a system of behavioral controls. First, as firms deal with an increasingly complex and unpredictable environment, there is a need for increased coordination across organizational barriers. Therefore, a control system based primarily on rigid strategies, rules, and regulations is dysfunctional. The use of rewards and culture to align individual and organizational goals becomes increasingly important. Second, as younger managers become more focused on a career rather than on a job, the role of culture and rewards in building organizational loyalty gains greater importance. Each of the three levers – culture, rewards, and boundaries – must work in a balanced and consistent manner.

Behavioral Control: Culture

Organizational culture is a system of:

Shared values (what is important).

Beliefs (how things work).

Organizational culture shapes a firm’s people, organizational structures, and control systems.

Organizational culture produces behavioral norms (the way we do things around here).

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Organizational culture = a system of shared values and beliefs that shape the company’s people, organizational structures, and control systems to produce behavioral norms. Culture has a powerful influence on what goes on within organizations and how they perform. Effective leaders understand culture’s importance and strive to shape and use it as one of their important levers of strategic control.

Behavioral Control: Role of Culture

Organizational culture sets implicit boundaries regarding:

Dress

Ethical matters

The way an organization conducts its business

A strong culture

Leads to greater employee engagement

Provides a common purpose and identity

Reduces monitoring costs

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Culture can play an important role by focusing on those values that sustain the organization’s primary source of competitive advantage. Culture sets implicit boundaries – unwritten standards of acceptable behavior – interests, ethical matters, and the way an organization conducts its business. Strong culture can lead to greater employee engagement and provide a common purpose and identity. By creating a framework of shared values, culture encourages individual identification with the organization and its objectives. Culture acts as a means of reducing monitoring costs.

Behavioral Control: Sustaining an Effective Culture

Effective organizational cultures must be:

Cultivated

Encouraged

Fertilized

Organizational cultures can be maintained by:

Storytelling

Rallies or pep talks by top executives

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Powerful organizational cultures just don’t happen overnight, and they don’t remain in place without a strong commitment—in terms of both words and deeds—by leaders throughout the organization. A viable and productive organizational culture can be strengthened and sustained. However it cannot be built or assembled; instead it must be cultivated, encouraged, and fertilized. Storytelling is one way effective cultures are maintained. See Strategy Spotlight 9.1. Rallies or pep talks by top executives also serve to reinforce a firm’s culture.

Behavioral Control: Rewards

Reward systems & incentive programs:

Powerful means of influencing an organization’s culture

Focusing efforts on high-priority tasks

Motivating individual & collective task performance

Can be an effective motivator & control mechanism

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Reward and incentive systems represent a powerful means of influencing an organization’s culture, focusing efforts on high-priority tasks, and motivating individual and collective task performance. Reward system = policies that specify who gets rewarded and why. Just as culture deals with influencing beliefs, behaviors, and attitudes of people within an organization, the reward system or incentive program – by specifying who gets rewarded and why – is an effective motivator and control mechanism.

Behavioral Control: Downside of Reward Systems

Potential downsides to reward systems:

Individual actions are not related to compensation; employees are rewarded for the wrong things.

Different business units have differing rewards systems.

Behavior reinforced within subcultures may reflect value differences in opposition to the dominant culture.

Reward systems may lead to information hoarding, working at cross purposes.

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While they can be powerful motivators, reward and incentive policies can also result in undesirable outcomes. If individual workers don’t see how their actions relate to how they are compensated, they can be demotivated. On the other hand, if the incentives are too closely tied to their individual work, this may lead to dysfunctional outcomes. For example, if a sales representative is rewarded for sales volume, she will be incentivized to sell at all costs. This may lead her to accept unprofitable sales or push sales through distribution channels the firm would rather avoid. Reward and incentive systems can also cause problems across organizational units. Subcultures within organizations may reflect differences among functional areas, products, services, and divisions. To the extent that reward systems reinforce such behavioral norms, attitudes, and belief systems, cohesiveness is reduced; important information is hoarded rather than shared, individuals begin working at cross purposes, and they lose sight of overall goals. Conflicts can also arise across divisions when divisional profits become a key compensation criterion.

Behavioral Control: Reward Systems Characteristics

Effective reward systems share common characteristics.

Objectives are clear, well understood, and broadly accepted.

Rewards are clearly linked to performance and desired behaviors.

Performance measures are clear and highly visible.

Feedback is prompt, clear, and unambiguous.

The compensation “system” is perceived as fair and equitable.

The structure is flexible; it can adapt to changing circumstances.

From Exhibit 9.4 Characteristics of Effective Reward and Evaluation Systems

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To be effective, incentive and reward systems need to reinforce basic core values, enhance cohesion and commitment to goals and objectives, and meet with the organization’s overall mission and purpose. Effective reward and incentive systems share a number of common characteristics. The perception that a plan is “fair and equitable” is critically important. The firm must also have the flexibility to respond to changing requirements as its direction and objectives change. Finally, incentive and reward systems don’t all have to be about financial rewards. Recognition can be a powerful motivator and managers can reward employees by giving them opportunities to lead projects or task forces. In sum, incentives and rewards can go well beyond simple pay to include formal recognition, praise, and the self-esteem that comes from feeling valued.

Behavioral Control: Boundaries (1 of 2)

Boundaries and constraints can be useful in:

Focusing individual efforts on strategic priorities

Providing short-term objectives and action plans to channel employee efforts by:

Setting specific, measurable objectives, including a specific time horizon for attainment

Making them achievable, yet challenging enough to motivate

Holding individual managers accountable for implementation

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Boundaries and constraints = rules that specify behaviors that are acceptable and unacceptable. Boundaries and constraints play a valuable role in focusing a company’s strategic priorities - for instance, concentrating effort and resources in key businesses while closing others can provide the firm with greater strategic focus and the potential for a stronger competitive advantage in the remaining areas. Short-term objectives and action plans represent boundaries that help allocate resources in an optimal manner and channel the efforts of employees at all levels. Performance is enhanced when individuals are encouraged to obtain specific, difficult, yet achievable, goals. Action plans are critical to the implementation of chosen strategies. Unless action plans are specific, there may be little assurance that managers have thought through all of the resource requirements for implementing their strategies. In addition, unless plans are specific, managers may not understand what needs to be implemented or have a clear time frame for completion. Finally, individual managers must be held accountable for the implementation.

Question (3 of 3)

Rules and regulations, rather than culture or rewards, would probably be used for strategic control at what type of company?

software developer

stock brokerage firm

manufacturer of mass-produced products

high-tech research facility

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Answer: C. Rules and regulations are especially helpful when consistency of product quality is critical.

Behavioral Control: Boundaries (2 of 2)

Boundaries and constraints can also:

Improve efficiency and effectiveness through rule-based controls, appropriate when:

Environments stable and predictable.

Employees are largely unskilled and interchangeable.

Consistency in product and services is critical.

The risk of malfeasance is extremely high.

Minimize improper and unethical conduct via:

Explicit rules

Anticorruption and anti-bribery policies

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Rule-based controls are most appropriate in organizations when the environment is stable, predictable; employees are unskilled, interchangeable; product and service consistency is critical; the risk of malfeasance is extremely high (e.g., in banking or casino operations). Guidelines can also be effective in setting spending limits and a range of discretion for employees and managers. Guidelines can be useful in specifying proper relationships with the company’s customers and suppliers, for instance, through anticorruption and anti-bribery policies.

Behavioral Control Systems: Situational Factors

Approach	Some Situational Factors
Culture: A system of unwritten rules that forms an internalized influence over behavior.	Often found in professional organizations. Associated with high autonomy. Norms are the basis for behavior.
Rules: Written and explicit guidelines that provide external constraints on behavior.	Associated with standardized output. Most appropriate when tasks are generally repetitive and routine. Little need for innovation or creative activity.
Rewards: The use of performance-base incentive systems to motivate.	Measurement of output and performance is rather straightforward. Most appropriate in organizations pursuing unrelated diversification. Rewards may be used to reinforce other means of control.

Exhibit 9.5 Organizational Control: Alternative Approaches

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The focus of a control system is on ensuring that the behavior of individuals at all levels of an organization is directed toward achieving organizational goals and objectives. The three fundamental types of control are culture, rewards and incentives, and boundaries and constraints. An organization may pursue one or a combination of them on the basis of a variety of internal and environmental factors. Not all organizations place the same emphasis on each type of control. Situational factors affect the combination and emphasis on each type of control. In most environments, organizations should strive to provide a system of rewards and incentives, coupled with a culture strong enough that boundaries become internalized. This reduces the need for external controls such as rules and regulations under the following conditions: first, hire the right people – individuals who already identify with the organization’s dominant values and have attributes consistent with them; institute training regimens that not only build skills, but also play a significant role in building a strong culture on the foundation of the organization’s dominant values; make sure the organization has managerial role models; make sure the reward systems are clearly aligned with the organization’s goals and objectives.

Control System: Corporate Governance

The strategic control mechanism corporate governance focuses on relationships among

Shareholders

Management (led by the CEO)

Board of Directors

Assumes the separation of owners (shareholders) & management in a modern corporation

Asks how corporations can succeed (or fail) in aligning managerial motives with

Interests of the shareholders

Interests of the board of directors

Corporate governance = the relationship among various participants in determining the direction and performance of corporations. The primary participants are (1) the shareholders, (2) the management, and (3) the Board of Directors. The strategic control mechanism known as corporate governance focuses on the need for both shareholders (the owners of the corporation) and their elected representatives, the Board of Directors, to actively ensure that management fulfills its overriding purpose of increasing long-term shareholder value. However, management cannot ignore the demands of other important firm stakeholders such as creditors, suppliers, customers, employees, and government regulators. At times of financial duress, powerful stakeholders can exert strong and legitimate pressures on managerial decisions. In general however, the attention to stakeholders other than the owners of the corporation must be addressed in a manner that is still consistent with maximizing long-term shareholder returns. Sound governance practices often lead to superior financial performance. Corporation = a mechanism created to allow different parties to contribute capital, expertise, and labor for the maximum benefit of each party. The corporate form of business organization has the ability to draw resources from a variety of groups and establish and maintain its own persona that is separate from all of them. The shareholders (investors) are able to participate in the profits of the enterprise without taking direct responsibility for the operations. The management can run the company without the responsibility of personally providing the funds. The shareholders have limited liability as well as rather limited involvement in the company’s affairs. However, they reserve the right to elect directors who have the fiduciary obligation to protect their interests. Columbia University professors Berle and Means addressed the divergence of the interests of the owners of the corporation from the professional managers who are hired to run it. They warned that widely dispersed ownership “released management from the overriding requirement that it serve stockholders.” The separation of ownership from management has given rise to a set of ideas called agency theory.

Corporate Governance: Agency Theory

Agency theory deals with the relationship between principals & agents.

What to do when the goals of the principals and agents conflict?

What to do when it is difficult or expensive for the principal to verify what the agent is actually doing?

What happens when the principal and the agent have different attitudes and preferences toward risk?

Agency theory = a theory of the relationship between principals and their agents, with emphasis on two problems: (1) the conflicting goals of principals and agents, along with the difficulty of principals to monitor the agents, and (2) the different attitudes and preferences toward risk of principals and agents. Principals are owners of the firm (stockholders or investors), and agents are the people paid by principals to perform the job on their behalf (management). Managers, or agents, are insiders with regard to the businesses they operate and thus are better informed than the principals. Thus, managers may act opportunistically in pursuing their own interests to the detriment of the corporation. Regarding risk, executives in a firm may favor additional diversification initiatives, for example, because these initiatives could increase the size of the firm and thus the level of executive compensation. At the same time, such diversification initiatives may erode shareholder value. On the other hand, executives who have large holdings of stock in their firms are more likely to have diversification strategies that are more consistent with shareholder interests, therefore increasing long-term returns. At times, top level managers engage in actions that reflect their self interest rather than the interests of shareholders. Governance mechanisms can minimize the potential for managers to act opportunistically.

Corporate Governance Mechanisms

Corporate governance mechanisms: aligning the interests of owners and managers through:

A committed and involved Board of Directors

Shareholder activism & active engagement

Managerial rewards and incentives

Contract-based outcomes – reward & compensation agreements that align management & stockholder interests

Making a decision about CEO duality – should the CEO also be chairman of the board of directors?

Governance mechanisms can minimize the potential for managers to act opportunistically, in their own self-interest. In addressing agency theory concerns, the interests of owners and managers can be aligned via three mechanisms: a committed and involved board of directors, the use of shareholder activism, and appropriate managerial rewards and incentives via reward and compensation agreements. Board of directors = a group that has a fiduciary duty to ensure that the company is run consistently with the long-term interests of the owners, or shareholders, of the corporation and acts as an intermediary between the shareholders and management. A committed and involved board of directors can monitor the behavior of managers and act in the best interests of the shareholders. Shareholders can also view themselves as share owners instead of shareholders and become actively engaged in the governance of the corporation. Shareholder activism = actions by large shareholders to protect their interests when they feel that managerial actions of a corporation diverge from shareholder value maximization. Finally, there are managerial incentives, sometimes called “contract-based outcomes,” which consist of reward and compensation agreements. Here the goal is to carefully craft managerial incentive packages to align the interests of management with those of the stockholders. Regarding managerial incentives, one of the most controversial issues in corporate governance is CEO duality. Should the CEO also be chairman of the board of directors? In many Fortune 500 firms, the same individual serves in both roles. Is this appropriate?

Corporate Governance Mechanisms: Board of Directors Effectiveness

An effective Board of Directors should

Become active, critical participants.

Ensure that strategic plans undergo rigorous scrutiny, focus on past, present, future.

Evaluate managers against high performance standards.

Take control of the succession process for upper management as well as the CEO.

Practice director independence.

No interlocking directorships

Insist that directors own significant stock in the company.

Build in the right expertise on the board.

Maintain norms of transparency and trust.

The board of directors acts as a fulcrum between the owners and controllers of a corporation. They are the intermediaries who provide a balance between a small group of key managers in the firm based at the corporate headquarters and a sometimes vast group of shareholders. In the United States, the law imposes on the board a strict and absolute fiduciary duty to ensure that a company is run consistent with the long-term interests of the owners – the shareholders. What makes for a good board of directors? Effective boards discussed potential performance synergies and the value of strategic alternatives open to the firm, assessed the firm’s value drivers, and evaluated potential resource reallocation options. Effective boards spent additional time together to discuss more forward-looking, strategic issues. Boards can also take control of the succession process, playing a more active role by forcing out CEOs who cannot deliver on performance. Another key component of top-ranked boards is director independence. Governance experts believe that a majority of directors should be free of all ties to either the CEO or the company. That means a minimum of “insiders” (past or present members of the management team) should serve on the board, and that directors and their firms should be barred from doing consulting, legal, or other work for the company. Interlocking directorships – in which CEOs and other top managers serve on each other’s boards – are not desirable. But perhaps the best guarantee that directors act in the best interest of shareholders is the simplest: most companies now insist that directors own significant stock in the company they oversee. There are also several actions that can have a positive influence on board dynamics as the board works to both oversee and advise management. See the list in the section Governance Mechanisms: Aligning the Interests of Owners and Managers.

Corporate Governance Mechanisms: Shareholder Activism

Shareholder activism assumes the following:

Individual shareholders have rights.

To sell stock, vote the proxy, bring suit for damages, get information, receive residual rights following the company’s liquidation

Collectively, shareholders have power.

To direct the course of corporations, file shareholder action suits, demand key issues be brought up for proxy votes

Institutional investors can be aggressive.

By reviewing performance, requesting changes in the firm’s governance structure, filing court action, pushing social initiatives

Shareholder activism = actions by large shareholders to protect their interests when they feel that managerial actions of a corporation diverge from shareholder value maximization. There are so many owners of the largest American corporations that it makes little sense to refer to them as “owners” in the sense of individuals becoming informed and involved in corporate affairs. However, even individual shareholders have rights, and, collectively, shareholders have the power to direct the course of corporations. Many institutional investors are aggressive in protecting and enhancing their investments. They are shifting from traders to owners. They are assuming the role of permanent shareholders and rigorously analyzing issues of corporate governance. In the process they are reinventing systems of corporate monitoring and accountability.

Corporate Governance Mechanisms: Managerial Rewards & Incentives

Boards are responsible for managerial rewards and incentives.

Boards can require that CEOs become substantial owners of company stock.

Salaries, bonuses, and stock options can be structured so as to provide rewards for superior performance and penalties for poor performance.

Dismissal for poor performance should be a realistic threat.

Incentive systems must be designed to help the company achieve its goals. One of the most critical roles of the board of directors is to create incentives that align the interests of the CEO and top executives with the interests of owners of the corporation, and long-term shareholder returns. Shareholders rely on CEOs to adopt policies and strategies that maximize the value of their shares. The above three basic policies can create the right monetary incentives for CEOs to maximize the value of their companies.

Corporate Governance Mechanisms: CEO Duality?

Unity of command: (in favor of) duality

Provides clear focus

Eliminates confusion and conflict

Enhances a firm’s responsiveness

Enables quick decisions based on first-hand knowledge

Agency theory: (in favor of) separation

Safeguards against corruption or incompetence

Removes conflict of interest, especially regarding CEO succession

Improves perceptions of legitimacy

CEO duality is one of the most controversial issues in corporate governance. It refers to the dual leadership structure where the CEO acts simultaneously as the chair of the board of directors. There are two schools of thought. The unity of command perspective assumes that when one person holds both roles, he or she is able to act more efficiently and effectively. CEO duality provides firms with a clear focus on both objectives and operations as well as eliminates confusion and conflict between the CEO and the chairman. Thus, it enables smoother, more effective strategic decision making. The agency theory perspective questions whether a board can act as a safeguard against corruption or incompetence when the possible source of that corruption and incompetence is sitting at the head of the table. CEO duality can create a conflict of interest that could negatively affect the interests of the shareholders. Duality also complicates the issue of CEO succession, when, for instance the CEO/Chairman may choose to retire as CEO but keep his or her role as the chairman. This puts the new CEO in a difficult position. Duality also serves to reinforce popular doubts about the legitimacy of the system as a whole and evokes images of bosses writing their own performance reviews and setting their own salaries. Research suggests that there is no one correct answer on duality but that firms should consider their current position and performance trends when deciding whether to keep the CEO and chairman position in the hands of one person.

External Corporate Governance Mechanisms

EXTERNAL governance control mechanisms:

The market for corporate control – if shareholders sell, stock value declines, increases possibility of takeover.

Takeover constraint – fear of acquisition by hostile raider

Auditors who verify the firm’s books

Banks and analysts who conduct in-depth studies of firms

Regulatory bodies that require disclosure of financial information

Securities and Exchange Commission (SEC)

Media and public activists who influence public perception

The separation of ownership and control that we discussed earlier requires multiple control mechanisms, some internal and some external, to ensure that managerial actions lead to shareholder value maximization. Further, society at large wants some assurance that this goal is met without harming other stakeholder groups. External governance control mechanisms = methods that ensure that managerial actions lead to shareholder value maximization and do not harm other stakeholder groups that are outside the control of the corporate governance system. If a board is ineffective in monitoring managers and is not exercising the oversight required of them, and the shareholders are passive and not taking any actions to monitor or discipline managers, managers may behave opportunistically. External markets provide one external mechanism that can partially solve these problems. The market for corporate control = an external control mechanism in which shareholders dissatisfied with the firm’s management sell their shares. As more stockholders vote with their feet, the value of the stock begins to decline. As the decline continues, at some point the market value of the firm becomes less than the book value. A corporate raider can then take over the company for a price less than the book value of the assets of the company, and then fire the underperforming management. Takeover constraint = the risk to management of the firm being acquired by a hostile raider. Auditors belong to independent organizations staffed by certified professionals who verify the firm’s books of accounts. Audits can unearth financial irregularities and ensure that financial reporting by the firm conforms to standard accounting practices. However, these audits often fail to catch accounting irregularities - see Enron & WorldCom. Banks have lent money to corporations and therefore have to ensure that the borrowing firm’s finances are in order and that the loan covenants are being followed. Stock analysts conduct ongoing in-depth studies of the firms that they follow and make recommendations to their clients. However, many analysts failed to grasp the gravity of the problems surrounding failed companies such as Lehman Brothers and Countrywide until the very end. Public corporations are required to disclose a substantial amount of financial information to external regulatory bodies such as the SEC. Finally, the financial press and media play an important indirect role in monitoring the management of public corporations. Public perceptions about a company’s financial prospects and the quality of its management are greatly influenced by the media, such as financial publications Bloomberg Businessweek and Fortune. Similarly, consumer groups and activist individuals often take a crusading role in exposing corporate malfeasance.

International Corporate Governance

In countries other than the United States and the UK, there is another perspective. Principal – principal conflicts (as opposed to principal – agent conflicts) involve:

Concentrated ownership, or family ownership

Motivation to engage in expropriation of minority shareholders for personal gain

Business groups who can take coordinated action

Japanese keiretsus, Korean chaebols

Few external regulatory constraints

The topic of corporate governance has long been dominated by agency theory and based on the explicit assumption of the separation of ownership and control. The central conflicts are principal – agent conflicts between shareholders and management. However, such an underlying assumption seldom applies outside of the United States and the United Kingdom. In emerging economies and continental Europe there is often concentrated ownership, along with extensive family ownership and control, business group structures, and weak legal protection for minority shareholders. Principal – principal conflicts = conflicts between two classes of principals – controlling shareholders and minority shareholders – within the context of the corporate governance system. (See Exhibit 9.6 for the differences between these two types of conflicts.) Strong family control is one of the leading indicators of concentrated ownership. Family members can become controlling (not necessarily majority) shareholders, and may take actions that decrease aggregate firm performance in order to realize personal gains. Expropriation of minority shareholders = activities that enrich the controlling shareholders at the expense of the minority shareholders. Business groups = a set of firms that, though legally independent, are bound together by a constellation of formal and informal ties and are accustomed to taking coordinated action. Business groups are especially common in emerging economies, and they differ from other organizational forms in that they are communities of firms without clear boundaries. Business groups have many advantages that can enhance the value of the firm. They often facilitate technology transfer or intergroup capital allocation that otherwise might be impossible because of inadequate institutional infrastructure. See Exhibit 9.7 for a model of these relationships.