strategic Mang

BUAD 4980

STRATEGIC MANAGEMENT

Chapter 10. Corporate Governance

( INTRODUCTION

Strategic controls involved monitoring organizational members to evaluate if activities are performed effectively. The purpose of strategic controls is to provide managers with (1) incentives to motivate managers & employees so they work toward corporate goals, and (2) feedback on how well an organization and its members are performing.

There are two sets of strategic controls: corporate governance (control of top managers), and organizational controls (control of other organizational members). Organizational controls are discussed in chapter 11.

Corporate governance is the set of mechanisms used to manage the relationship among stakeholders and to determine and control the strategic direction and performance of organizations. A brief discussion of stakeholders is needed to better understand corporate governance.

( STAKEHOLDERS

1. Definition: Stakeholders are individuals and organizations (institutions) with interests in an organization.

2. Types of stakeholders: there are three sets of stakeholders

- Capital market stakeholders: shareholders, lenders

- Product market stakeholders: customers, suppliers, communities, unions

- Organizational stakeholders: managers, employees

3. Conflicting interests: Stakeholders have different interests. Often those interests are in conflict (for example conflict between employees-owners, employees-managers). At the core of corporate governance is the conflict between owners and managers. It is the responsibility of corporate managers to manage conflicting interests

4. Assuming corporate responsibilities: To balance conflicting interests, managers need to assume their corporate responsibilities, that is, they should balance different and often conflicting interests. So when designing vision & mission, and when setting goals & objectives, they need to balance the interests of various stakeholders.

5. Corporate responsibilities: Managers have several responsibilities:

- Basic responsibilities: Economic responsibilities (paying dividends, wages, debts, etc.) and legal responsibilities (paying taxes, meeting legal standards, abiding by laws)

- Social responsibilities: Ethical responsibilities (actions valued by society but not yet put into laws), and discretionary responsibilities (actions not yet valued by society)

( SEPARATION OF OWNERSHIP AND MANAGEMENT

1. Small organizations: There is no separation between ownership and management, because the owner is also the manager:

- Need for information processing is simple

- Little organizational skills needed to manage.

- No control, as there is little to no governance problem

2. Large organizations: Separation ownership and management:

- Complexity: large organizations are too big to manage because of increased information processing requirements

- Professional managers: the need for individuals with sophisticated skills to manage complexity results in the hiring of professional managers

- Owners will engage in agency relationships with professional managers

3. Agency relationships:

- An agency relationship exists when the owner (the principal) delegates decision making to a professional manager (the agent) in return for a compensation.

- Corporate governance problem: the existence of agency relationships has the potential to result in agency problem (also known as corporate governance problem). Corporate governance problem refers to managers’ tendency to serve own interests instead of serving owners’ interests.

- Opportunism: corporate governance problem is caused by managerial opportunism. Opportunism is defined as seeking self-interest with guile (i.e. with deceptive behavior).

( GOVERNANCE MECHANISMS

Governance mechanisms are control actions taken to minimize corporate governance problem. There are several governance mechanisms. Four governance mechanisms will be discussed, including three internal governance mechanisms (ownership concentration, the board of directors, and executive compensation), and one external governance mechanism (the market for corporate control).

1. Ownership concentration:

Ownership concentration is a governance mechanism defined both by the number of large-block owners and by the total percentage of the firm’s shares that they own. Ownership is concentrated when there are large-block shareholders (investors who typically own at least five percent of the firm’s shares). Ownership is diffused when there is a large number of shareholders with small holdings (with few/no large-block shareholders).

Diffuse ownership produces weak monitoring of managerial decisions. The reason is because several small owners will be ineffective in coordinating their actions to control corporate managers.

Concentrated ownership can be effective in controlling top managers. The reason is because large-block shareholders will be motivated to coordinate their actions as they have invested large amounts of financial resources. In recent years, large-block ownership by individuals has declined, but they have been replaced by significant positions held by institutional owners. Institutional owners are large-block shareholder positions controlled by financial institutions, such as stock mutual funds and pension funds.

2. Board of directors:

The board of directors is a governance mechanism whereby a group of elected individuals (directors) have the primary responsibility to act in the owners’ interests by formally monitoring and controlling the corporation’s top-level executives.

The board of directors is comprised of insiders, related outsiders, and outsiders. Insiders are represented by the firm’s CEO and a few top-level managers. Related outsiders are individuals who are not involved in the firm’s day-to-day operations, but may have a relationship with the company (e.g. the firm’s legal counsel, a large customer or supplier). Outsiders are individuals who are independent of the firm (examples include the president of a university or a community volunteer).

Because the primary role of the board of directors is to monitor and ratify major managerial actions to protect the interests of owners, there is a call by advocates of board reform that outsiders should represent a significant majority of a board’s membership.

3. Executive Compensation:

Executive compensation is a governance mechanism that seeks to align managers’ and owners’ interests through salary, bonus, and long-term incentive compensation such as stock options. It is difficult to assess the effectiveness of executive compensation for a number of reasons. First, compensation is often linked to more measurable outcomes such as financial performance (but not strategic performance). Second, because decisions made by top-level managers are likely to affect firm performance over an extended period of time, it is difficult to assess the effect of current decisions using current period performance. Third, many variables (or outside factors) intervene between management behavior and firm performance (e.g., uncontrollable shifts in the environment).

The compensation received by top-level managers, especially by CEOs, is often a subject of controversy. Large CEO compensation packages result mostly from the inclusion of stock options and stock in the total pay packages. Research has shown that managers owning more than one percent of the firm’s stock are less likely to be forced out of their jobs, even when the firm is performing poorly. Also, annual bonuses may provide incentives to pursue short-run objectives at the expense of the firm’s long-term interests.

4. Market for corporate control:

The market for corporate control is an external governance mechanism that consists of individuals and firms who buy ownership positions in (or take over) potentially undervalued firms. They do this in order to form a new division in an established diversified firm, merge two previously separate firms, and usually replace the target firm’s management team to revamp the strategy that caused low firm performance.

Because of the threat of dismissal, managers have devised a number of defensive tactics designed to prevent takeovers. These tactics include:

- Managerial pay interventions, such as golden parachutes (contract specifying that a top manager will receive a large and lucrative benefit in the event the company is acquired and the employment is terminated)

- Asset restructuring, such as divesting a business unit or division

- Financial restructuring—e.g., stock repurchases, paying out a firm’s free cash flows as a dividend

- Changing the state of incorporation

- Making targeted shareholder repurchases (known as greenmail)

( GOVERNANCE MECHANISMS AND ETHICAL BEHAVIOR

Governance mechanisms discussed focus on ensuring that managers work effectively toward meeting their obligation to maximize shareholder wealth. However, shareholders are only one group of the firm’s stakeholders. Over the long term, the demands of other key stakeholders—such as employees, customers, suppliers, and the community—also must be satisfied in order to maximize shareholder wealth. For that reason and others, governance mechanisms must be carefully designed and implemented so that managers’ attention is not focused on maximizing short-term returns and to ensure that they consider the interests of all stakeholders (i.e. they must assume their corporate responsibilities).