Case Study ( 8 sections ) on the Governance failure at Satyam

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PART 3: STRATEGIC ACTIONS:

STRATEGY IMPLEMENTATION

CHAPTER 10 CORPORATE GOVERNANCE

Authored by:

Marta Szabo White, PhD.

Georgia State University

THE STRATEGIC MANAGEMENT PROCESS

©2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

KNOWLEDGE OBJECTIVES

● Define corporate governance and explain why it is used to monitor and control top-level managers’ decisions.

● Explain why ownership is largely separated from managerial control in organizations.

● Define an agency relationship and managerial opportunism and describe their strategic implications.

● Explain the use of three internal governance mechanisms to monitor and control managers’ decisions.

KNOWLEDGE OBJECTIVES

● Discuss the types of compensation top-level managers receive and their effects on managerial decisions.

● Describe how the external corporate governance mechanism—the market for corporate control—restrains top-level managers’ decisions.

● Discuss the nature and use of corporate governance in international settings, especially in Germany, Japan, and China.

● Describe how corporate governance fosters the making of ethical decisions by a firm’s top-level managers.

CORPORATE GOVERANCE: WHAT IS ALL THE FUSS ABOUT?

■ Corporate governance can destroy or create value for a firm.

■ It is concerned with:

1. strengthening the effectiveness of a company’s board of directors

2. verifying the transparency of a firm’s operations

3. enhancing accountability to shareholders

4. incentivizing executives

5. maximizing value-creation for stakeholders and shareholders

OPENING CASE

CORPORATE GOVERANCE: WHAT IS ALL THE FUSS ABOUT?

■ Given recent criticisms, boards’ actions in nations throughout the world are being more carefully scrutinized and regulated.

■ In the U.S., that after being fired by their firm, a number of CEOs still remain as members of other firms’ boards of directors, is drawing close attention.

■ Corporate governance is weak in many Chinese firms and there is concern about the validity and reliability of some auditors’ work and the quality of companies’ financial statements.

OPENING CASE

CORPORATE GOVERANCE: WHAT IS ALL THE FUSS ABOUT?

■ The reason there is a “fuss” about corporate governance is that these activities are critical to globally signaling transparency coupled with strategic competitiveness.

■ Corporate governance fundamentals:

Corporate Directors should:

● Focus on creating long-term value for shareholders

● Use performance-related pay to attract and retain senior management

● Exercise sound business judgment to evaluate opportunities and manage risk

● Communicate with key shareholders

OPENING CASE

CORPORATE GOVERNANCE

Corporate governance: a set of mechanisms used to manage the relationships (and conflicting interests) among stakeholders, and to determine and control the strategic direction and performance of organizations (aligning strategic decisions with company values)

When CEOs are motivated to act in the best interests of the firm—particularly, the shareholders—the company’s value should increase.

Successfully dealing with this challenge is important, as evidence suggests that corporate governance is critical to firms’ success.

CORPORATE GOVERNANCE

Corporate Governance Emphasis

Two reasons:

Apparent failure of corporate governance mechanisms to adequately monitor and control top-level managers’ decisions during recent times

Evidence that a well-functioning corporate governance and control system can create a competitive advantage for an individual firm

CORPORATE GOVERNANCE

Corporate Governance Concern

Effective corporate governance is of interest to nations as it reflects societal standards:

Firms’ shareholders are treated as key stakeholders as they are the company’s legal owners

Effective governance can lead to competitive advantage

How nations choose to govern their corporations affects firms’ investment decisions; firms seek to invest in nations with national governance standards that are acceptable

SEPARATION OF OWNERSHIP AND MANAGERIAL CONTROL

INTRODUCTION

Historically, firms managed by founder-owners and descendants

Separation of ownership and managerial control allows each group to focus on what it does best:

Shareholders bear risk

Managers formulate and implement strategy

SEPARATION OF OWNERSHIP AND MANAGERIAL CONTROL

INTRODUCTION (cont’d)

Small firms’ managers are high percentage owners, which implies less separation between ownership and management control

Family-owned businesses face two critical issues:

As they grow, they may not have access to all needed skills to manage the growing firm and maximize its returns, so may need outsiders to improve management

They may need to seek outside capital (whereby they give up some ownership control)

SEPARATION OF OWNERSHIP AND MANAGERIAL CONTROL

Basis of the modern corporation:

Shareholders purchase stock, becoming residual claimants

Shareholders reduce risk by holding diversified portfolios

Shareholder value reflected in price of stock

Professional managers are contracted to provide decision making

Modern public corporation form leads to efficient specialization of tasks:

Risk bearing by shareholders

Strategy development and decision making by managers

SEPARATION OF OWNERSHIP AND MANAGERIAL CONTROL

SHAREHOLDERS

MANAGERS

Professional managers contracted to provide decision making

Shareholders purchase stock

Entitled to income (residual returns)

Strategy development and decision making by managers

Risk bearing by shareholders—firm’s expenses may exceed revenues

Investment risk is managed through a diversified investment portfolio

SEPARATION OF OWNERSHIP AND MANAGERIAL CONTROL

FIGURE 10.1

An Agency Relationship

SEPARATION OF OWNERSHIP AND MANAGERIAL CONTROL

AGENCY RELATIONSHIPS

Managerial opportunism: seeking self-interest with guile (i.e., cunning or deceit)

Opportunism: an attitude and set of behaviors

Decisions in managers’ best interests, contrary to shareholders’ best interests

Decisions such as these prevent maximizing shareholder wealth

Principals establish governance and control mechanisms to prevent agents from acting opportunistically.

PRODUCT DIVERSIFICATION AS AN EXAMPLE OF AN AGENCY PROBLEM

Two benefits that accrue to top-level managers and not to shareholders:

1. Increase in firm size: product diversification usually increases the size of a firm; that size is positively related to executive compensation

2. Firm portfolio diversification, which can reduce top executives’ employment risk (i.e., job loss, loss of compensation, and loss of managerial reputation)

Diversification reduces these risks because a firm and its managers are less vulnerable to reductions in demand associated with a single/limited number of businesses.

FREE CASH FLOW AS AN EXAMPLE OF AN AGENCY PROBLEM

Free cash flow: resources remaining after the firm has invested in all projects that have positive net present values within its current businesses

Use of Free Cash Flows

■ Managers inclination to over-diversify and invest these funds in additional product diversification

■ Shareholders prefer distribution as dividends, so they can control how the cash is invested

MANAGER AND SHAREHOLDER RISK AND DIVERSIFICATION

FIGURE 10.2

Manager and Shareholder Risk and Diversification

MANAGER AND SHAREHOLDER RISK AND DIVERSIFICATION

RISK

In general, shareholders prefer riskier strategies than managers

DIVERSIFICATION

Shareholders prefer more focused diversification

Managers prefer greater diversification, a level that maximizes firm size and their compensation while also reducing their employment risk

However, their preference is that the firm’s diversification falls short of where it increases their employment risk and reduces their employment opportunities (e.g., acquisition target from poor performance)

AGENCY COSTS AND GOVERNANCE MECHANISMS

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

● Principals may engage in monitoring behavior to assess the activities and decisions of managers

● However, dispersed shareholding makes it difficult and inefficient to monitor management’s behavior.

AGENCY COSTS AND GOVERNANCE MECHANISMS

● Boards of Directors have a fiduciary duty to shareholders to monitor management

● However, Boards of Directors are often accused of being lax in performing this function

● Costs associated with agency relationships, and effective governance mechanisms should be employed to improve managerial decision making and strategic effectiveness

● In response, U.S. Congress enacted:

▪ Sarbanes-Oxley (SOX) Act in 2002

▪ Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in mid-2010

AGENCY PROBLEMS GOVERNANCE MECHANISMS

GOVERNANCE MECHANISMS

AGENCY RELATIONSHIPS

AGENCY PROBLEMS

AGENCY COSTS AND GOVERNANCE MECHANISMS

All of the following are consequences of the Sarbanes-Oxley Act:

● Decrease in foreign firms listing on U.S. stock exchanges at the same time as listing on foreign exchanges increased

● Internal auditing scrutiny has improved and there is greater trust in financial reporting

● Section 404 creates excessive costs for firms

Determining governance practices that strike a balance between protecting stakeholders’ interests and allowing firms to implement strategies with some degree of risk is difficult

GOVERNANCE MECHANISMS

Three internal governance mechanisms and a single external one are used in the modern corporation.

The three internal governance mechanisms are:

1. Ownership Concentration, represented by types of shareholders and their different incentives to monitor managers

2. Board of Directors

3. Executive Compensation

The external corporate governance mechanism is:

4. Market for Corporate Control

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.

GOVERNANCE MECHANISMS

Internal Governance Mechanisms

Ownership Concentration

• Relative amounts of stock owned by individual shareholders and institutional investors

Board of Directors

• Individuals responsible for representing the firm’s owners by monitoring top-level managers’ strategic decisions

Executive Compensation

• Use of salary, bonuses, and long-term incentives to align managers’ interests with shareholders’ interests

External Governance Mechanism

Market for Corporate Control

• The purchase of a company that is underperforming relative to industry rivals in order to improve the firm’s strategic competitiveness

OWNERSHIP CONCENTRATION

Ownership

Concentration

Governance mechanism defined by both the number of large-block shareholders and the total percentage of shares owned

Large block shareholders: shareholders owning a concentration of at least 5 percent of a corporation’s issued shares

Large block shareholders have a strong incentive to monitor management closely

They may also obtain Board seats, which enhances their ability to monitor effectively

OWNERSHIP CONCENTRATION

Ownership

Concentration

Institutional owners: financial institutions such as stock mutual funds and pension funds that control large block shareholder positions

The growing influence of institutional owners

Provides size to influence strategy and the incentive to discipline ineffective managers

Increased shareholder activism supported by SEC rulings in support of shareholder involvement and control of managerial decisions

OWNERSHIP CONCENTRATION

Ownership

Concentration

Shareholder activism:

Shareholders can convene to discuss corporation’s direction

If a consensus exists, shareholders can vote as a block to elect their candidates to the board

Proxy fights

There are limits on shareholder activism available to institutional owners in responding to activists’ tactics

BOARD OF DIRECTORS

Ownership

Concentration

Board of Directors

Group of shareholder-elected individuals (usually called ‘directors’) whose primary responsibility is to act in the owners’ interests by formally monitoring and controlling the corporation’s top-level executives

BOARD OF DIRECTORS

Ownership

Concentration

Board of Directors

As stewards of an organization's resources, an effective and well-structured board of directors can influence the performance of a firm:

Oversee managers to ensure the company is operated in ways to maximize shareholder wealth

Direct the affairs of the organization

Punish and reward managers

Protect shareholders’ rights and interests

Protect owners from managerial opportunism

BOARD OF DIRECTORS

Ownership

Concentration

Board of Directors

Three director classifications: Insider, related outsider, and outsider:

Insiders: the firm’s CEO and other top-level managers

Related outsiders: individuals uninvolved with day-to-day operations, but who have a relationship with the firm

Outsiders: individuals who are independent of the firm’s day-to-day operations and other relationships

BOARD OF DIRECTORS

Ownership

Concentration

Board of Directors

Criticisms of Boards of Directors include that they:

Too readily approve managers’ self-serving initiatives

Are exploited by managers with personal ties to board members

Are not vigilant enough in hiring and monitoring CEO behavior

Lack agreement about the number of and most appropriate role of outside directors

BOARD OF DIRECTORS

Ownership

Concentration

Board of Directors

Historically, BOD dominated by inside managers:

Managers suspected of using their power to select and compensate directors

NYSE implemented an audit committee rule requiring outside directors to head audit committee (a response to SEC’s proposal requiring audit committees be made up of outside directors)

Sarbanes-Oxley Act passed leading to BOD changes

Corporate governance becoming more intense through BOD mechanism

BOD scandals led to trend of separating roles of CEO and Board Chairperson

BOARD OF DIRECTORS

Ownership

Concentration

Board of Directors

Outside directors:

Improve weak managerial monitoring and control that corresponds to inside directors

Tend to emphasize financial controls, to the detriment of risk-related decisions by managers, as they do not have access to daily operations and a high level of information about managers and strategy

Large number of outsiders can create problems

BOARD OF DIRECTORS

Ownership

Concentration

Board of Directors

Outside directors (problems)

Limited contact with the firm’s day-to-day operations and incomplete information about managers:

Results in ineffective assessments of managerial decisions and initiatives

Leads to an emphasis on financial, rather than strategic controls to evaluate performance of managers and business units, which could reduce R&D investments and allow top-level managers to pursue increased diversification for the purpose of higher compensation and minimizing their employment risk

BOARD OF DIRECTORS

Ownership

Concentration

Board of Directors

Enhancing the effectiveness of the Board of Directors:

Increase the diversity of the backgrounds of board members (e.g., public service, academic, scientific; ethnic minorities and women; different countries)

Strengthen internal management and accounting control systems

Establish and consistently use formal processes to evaluate the board’s performance

BOARD OF DIRECTORS

Ownership

Concentration

Board of Directors

Enhancing the effectiveness of the Board of Directors:

4. Modify the compensation of directors, especially reducing or eliminating stock options as part of their package

5. Create the “lead director” role that has strong powers with regard to the board agenda and oversight of non-management board member activities

6. Require that directors own significant equity stakes in the firm to keep focus on shareholder interests

EXECUTIVE COMPENSATION

Ownership

Concentration

Board of Directors

Executive

Compensation

Governance mechanism that seeks to align the interests of top managers and owners through salaries, bonuses, and long-term incentive compensation, such as stock awards and stock options

Thought to be excessive and out of line with performance

EXECUTIVE COMPENSATION

Ownership

Concentration

Board of Directors

Executive

Compensation

Factors complicating executive compensation:

Strategic decisions by top-level managers are complex, non-routine and affect the firm over an extended period, making it difficult to assess the current decision effectiveness

Other intervening variables affect the firm’s performance over time

Alignment of pay and performance: complicated board responsibility

The effectiveness of pay plans as a governance mechanism is suspect

EXECUTIVE COMPENSATION

Ownership

Concentration

Board of Directors

Executive

Compensation

The effectiveness of executive compensation:

Performance-based compensation used to motivate decisions that best serve shareholder interest are imperfect in their ability to monitor and control managers

Incentive-based compensation plans intended to increase firm value, in line with shareholder expectations, subject to managerial manipulation to maximize managerial interests

EXECUTIVE COMPENSATION

Ownership

Concentration

Board of Directors

Executive

Compensation

The effectiveness of executive compensation:

Many plans seemingly designed to maximize manager wealth rather than guarantee a high stock price that aligns the interests of managers and shareholders

Stock options are popular:

Repricing: strike price value of options is commonly lowered from its original position

Backdating: options grant is commonly dated earlier than actually drawn up to ensure an attractive exercise price

EXECUTIVE COMPENSATION

Ownership

Concentration

Board of Directors

Executive

Compensation

Limits on the effectiveness of executive compensation:

Unintended consequences of stock options

Firm performance not as important as firm size

Balance sheet not showing executive wealth

Options not expensed at the time they are awarded

MARKET FOR CORPORATE CONTROL

Ownership

Concentration

Board of Directors

Executive

Compensation

Market for

Corporate Control

External governance: a mechanism consisting of a set of potential owners seeking to acquire undervalued firms and earn above-average returns on their investments

Becomes active only when internal controls have failed

Ineffective managers are usually replaced in such takeovers

MARKET FOR CORPORATE CONTROL

Ownership

Concentration

Board of Directors

Executive

Compensation

Market for

Corporate Control

Need for external mechanisms exists to:

Address weak internal corporate governance

Correct suboptimal performance relative to competitors

Discipline ineffective or opportunistic managers

Threat of takeover may lead firm to operate more efficiently

Changes in regulations have made hostile takeovers difficult

MARKET FOR CORPORATE CONTROL

Ownership

Concentration

Board of Directors

Executive

Compensation

Market for

Corporate Control

Managerial defense tactics increase the costs of mounting a takeover

Defense tactics may require:

Asset restructuring

Changes in the financial structure of the firm

Shareholder approval

External mechanism is less precise than the internal governance mechanisms

HOSTILE TAKEOVER DEFENSE STRATEGIES

TABLE 10.2

Hostile Takeover Defense Strategies

HOSTILE TAKEOVER DEFENSE STRATEGIES

TABLE 10.2

Hostile Takeover Defense Strategies

(Cont’d)

INTERNATIONAL CORPORATE GOVERNANCE

Corporate Governance in Germany

Concentration of ownership is strong

In many private German firms, the owner and manager may be the same individual

In these instances, agency problems are not present.

In publicly traded German corporations, a single shareholder is often dominant, frequently a bank

The concentration of ownership is an important means of corporate governance in Germany, as it is in the U.S.

INTERNATIONAL CORPORATE GOVERNANCE

Corporate Governance in Germany

Banks exercise significant power as a source of financing for firms.

Two-tiered board structures, required for larger employers (more than 2,000 employees), place responsibility for monitoring and controlling managerial decisions and actions with separate groups.

Power sharing includes representation from the community as well as unions.

INTERNATIONAL CORPORATE GOVERNANCE

Corporate Governance in Germany

Germany: Two-tiered Board

Vorstand

Aufsichtsrat

Employees

Union Members Shareholders

The management board is responsible for all the functions of strategy and management

Responsible for appointing members to the Vorstand

Responsible for appointing members to the Aufsichtsrat

INTERNATIONAL CORPORATE GOVERNANCE

Corporate Governance in Germany

● Proponents of the German structure suggest that it helps prevent corporate wrongdoing and rash decisions by “dictatorial CEOs”

● Critics maintain that it slows decision making and often ties a CEO’s hands

● The corporate governance practices in Germany make it difficult to restructure companies as quickly as in the U.S.

● Banks are powerful; private shareholders rarely have major ownership positions in German firms

INTERNATIONAL CORPORATE GOVERNANCE

Corporate Governance in Germany

● Large institutional investors, e.g., pension funds and insurance companies, are also relatively insignificant owners of corporate stock

● Less emphasis on shareholder value

● This traditional system produced agency costs because of a lack of external ownership power

● Changes - German firms with listings on U.S. stock exchanges have increasingly adopted executive stock option compensation as a long-term incentive pay policy

INTERNATIONAL CORPORATE GOVERNANCE

Corporate Governance in Japan

● Cultural concepts of obligation, family, and consensus affect attitudes toward governance

● Close relationships between stakeholders and a company are manifested in cross-shareholding, and can negatively impact efficiencies

● Keiretsus: strongly interrelated groups of firms tied together by cross-shareholdings

● Banks (especially “main bank”) are highly influential with firm’s managers

INTERNATIONAL CORPORATE GOVERNANCE

Corporate Governance in Japan

● Japan has a bank-based financial and corporate governance structure whereas the United States has a market-based financial and governance structure

● Banks play an important role in financing and monitoring large public firms

● Powerful government intervention

● Despite the counter-cultural nature of corporate takeovers, changes in corporate governance have introduced this practice

INTERNATIONAL CORPORATE GOVERNANCE

Corporate Governance in Japan

Changes:

● Deregulation in the financial sector has reduced the cost of hostile takeovers, facilitating Japan’s previously nonexistent market for corporate control

● Diminishing role of banks monitoring and controlling managerial behavior, due to their development as economic organizations

● CEOs of both public and private companies receive similar levels of compensation, which is closely tied to observable performance goals

INTERNATIONAL CORPORATE GOVERNANCE

Corporate Governance in China

Changes:

● Major changes over the past decade

● Privatization of business and the development and integrity of equity market

● The stock markets in China remain young and underdeveloped; in their early years, they were weak because of significant insider trading, but with stronger governance these markets have improved

● The state dominates—directly or indirectly—the strategies that most firms employ

INTERNATIONAL CORPORATE GOVERNANCE

Corporate Governance in China

● Firms with higher state ownership have lower market value and more volatility

● The state is imposing social goals on these firms and executives are not trying to maximize shareholder wealth

● Moving toward a Western-style model

● Chinese executives are being compensated based on the firm’s financial performance

● Much work remains if the governance of Chinese companies is to meet international and Western standards

INTERNATIONAL CORPORATE GOVERNANCE

Global Corporate Governance

Relatively uniform governance structures are evolving

These structures are moving closer to the U.S. corporate governance model

Although implementation is slower, merging with U.S. practices is occurring even in transitional economies

GOVERNANCE MECHANISMS AND ETHICAL BEHAVIOR

It is important to serve the interests of the firm’s multiple stakeholder groups!

Capital Market

Stakeholders

Product Market

Stakeholders

Organizational

Stakeholders

In the U.S., shareholders (in the capital market group) are the most important stakeholder group served by the Board of Directors

Governance mechanisms focus on control of managerial decisions to protect shareholder interests

GOVERNANCE MECHANISMS AND ETHICAL BEHAVIOR

It is important to serve the interests of the firm’s multiple stakeholder groups!

Capital Market

Stakeholders

Product Market

Stakeholders

Organizational

Stakeholders

Product market stakeholders (customers, suppliers, and host communities) and organizational stakeholders (managerial and non-managerial employees) are also important stakeholder groups and may withdraw their support of the firm if their needs are not met, at least minimally

GOVERNANCE MECHANISMS AND ETHICAL BEHAVIOR

It is important to serve the interests of the firm’s multiple stakeholder groups!

Capital Market

Stakeholders

Product Market

Stakeholders

Organizational

Stakeholders

Some observers believe that ethically responsible companies design and use governance mechanisms that serve all stakeholders’ interests

Importance of maintaining ethical behavior is seen in the examples of Enron, Arthur Andersen, WorldCom, HealthSouth and Tyco

GOVERNANCE MECHANISMS AND ETHICAL BEHAVIOR

● For 2011, some of World Finance’s “Best Corporate Governance Awards” by country were given to:

◘ Royal Bank of Canada (Canada)

◘ Vestas Wind Systems A/S (Denmark)

◘ BSF AG (Germany)

◘ Empresas ICA (Mexico)

◘ Cisco Systems (United States)

GOVERNANCE MECHANISMS AND ETHICAL BEHAVIOR

● These awards are determined by analyzing a number of corporate governance issues:

◘ Board accountability/financial disclosure

◘ Executive compensation

◘ Shareholder rights

◘ Ownership base

◘ Takeover provisions

◘ Corporate behavior

◘ Overall responsibility exhibited by firm