Ch11 Discussion Light

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Strategy Management
Robert E. Hoskisson; Michael A. Hitt; R. Duane Ireland

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  • Corporate Governance Instructor notes are provided for four topics in this set of slides: • How to increase product diversification and how to intensify effort to innovate without increased agency problems (see first slide titled “Agency Relationship: Owners and Managers“ • The growing influence of institutional owners (see first slide titles “Governance Mechanisms“) • A discussion of the risks associated with boards dominated by outsiders (see third slide titled “Governance Mechanisms“) • A continued discussion of the role played by outsiders (see first slide titled “Corporate Governance and Ethical Behavior“) Note: See text for citation list.
  • Agency Relationships Owners and Managers How to increase product diversification and how to intensify effort to innovate without increased agency problems? Firms undertake a variety of actions to reduce risk through diversification, including entering diverse lines of business, joining alliances, taking on temporary partners, and outsourcing risky projects, including R&D. The challenge, as explained in the book, is that shareholders do not directly benefit from risk-reducing diversification strategies when they can replicate this diversification on their own. Diversification, therefore, is often seen as managers’ opportunistic pursuit of their own self-interests at the expense of the shareholders who can, if they so desire, diversify their individual portfolios simply by buying shares in other companies. While this view reflects the influence of agency theory, recently such views have been challenged by stewardship theory (Donaldson, 1990a; Donaldson & Davis, 1991), a framework presuming that managers are actually seeking to maximize organizational performance. For instance, one reason for diversifying would be to enhance company profit and growth prospects by reducing dependence on static or declining products, markets, and even industries. In the parlance of the I/O model discussed in Chapter 1, such a motive might lead companies to increase diversification into technologies or industries where profit rates are increasing most and to those where the competitive dynamism is relatively more stable. Managers might also opt to diversify for earnings stability and economies of scale. In short, diversification strategies might represent opportunism, but it might also reflect management rational and genuine response to financial adversity and/or the need for improved financial performance for their company.
  • Governance Mechanisms The Growing Influence of Institutional Owners (p. 350) The discussion of the relationship between corporate ownership and performance was initiated as far back as the 1930s, but it remains an issue today. Pioneering researchers in corporate governance show that companies with separated ownership and control functions operate with different managerial rules in investment decision-making from those in which ownership and control are combined in a single decision-maker. Different managerial rules are caused by the different basis on which the stakeholders optimize the tradeoff between their profit and utility maximization and the distribution of decision-making and risk-bearing functions. With diffused ownership and a lesser number of shares, an individual shareholder’s control is diluted while a manager’s control increases. This gives rise to conflict of interests resulting in less than optimal value for the shareholders. Erosion of value also comes from agency costs arising from ensuring that management acts in shareholders’ interests. A manager may behave opportunistically by choosing to exchange profits for personal benefits, such as “on-the-job” consumption. Thus consuming away the economic goods today rather than preserving them for the future. It is assumed that large-block investors and institutional ownership have both the size and the incentive to discipline ineffective managers and thus to influence a firm’s strategic choice. The shift in governance whereby ownership of many modern corporations is concentrated in the hands of institutional investors might come with a high price tag vis-à- vis strategic choice and long-term planning. For example, institutional investors are overly focused on current profitability, which might conflict with future period earnings due to investments in risky R&D projects and exploration of new business models. Moreover, as suggested in the book, even very strong institutional investors might not avert financial disaster. For example, CalPERS, which provides retirement and health coverage to over 1.3 million employees and is one of the largest public employee pension funds in the United States, had invested in Enron! (Continued on next slide.)
  • Governance Mechanisms (cont.) The Growing Influence of Institutional Owners (p. 350) (cont.) Interestingly, over the past decade the world’s leading private equity firms consistently have delivered internal rates of return twice as large as the S&P 500’s. They’ve achieved this is by adding value to the underlying operations (Rogers, Holland, & Haas, 2002). For example, private equity firms: • Clearly define their investment thesis and its time frame to fruition • Hire managers who act like owners • Focus on a few measures of success that all employees understand • Make capital work hard or otherwise re-deploy under-performing assets quickly • Make the center an active shareholder Ask Can institutional owners understand and act like managers of private equity firms? (Continued on next slide.)
  • Governance Mechanisms (cont.) The Growing Influence of Institutional Owners (p. 350) (cont.) Board of Directors (p. 353) Much of the governance literature advocates boards dominated by outsiders. What might be some of the risks associated with boards dominated by outsiders? As discussed in the book, a large number of outsiders can create several problems. First, outsiders have limited contact with the firm’s day-to-day operations and incomplete information about managers. This, in turn, leads to ineffective assessments of managerial decisions and initiatives. Second, in the absence of full information, outsider-dominated boards emphasize the use of financial, as opposed to strategic, controls to gather performance information to evaluate managers’ and business units’ performances. Strong reliance on financial evaluations shifts risk to managers, who, in turn, may reduce R&D investments, increase diversification, and pursue higher compensation to offset their employment risk. (Continued on next slide.)
  • Governance Mechanisms (cont.) The Growing Influence of Institutional Owners (p. 350) (cont.) Board of Directors (p. 353) (cont.) Recently, Phan and his colleagues (2002) explained the relationships between corporate governance and innovation (R&D expenditures, patents, and new products) in 86 publicly listed pharmaceutical firms. Consistent with agency theory, they found that the presence of large block private and institutional shareholders—controlling for firm size and performance — positively influenced innovation. They demonstrated that CEO duality was positively related to R&D expenditures, and that boards with more insiders were positively associated with the number of new products. In short, in the highly turbulent pharmaceutical industry, where risky decisions have to be made under substantial uncertainty, active ownership, unitary command structures, and strategically involved boards provide superior explanatory power for the governance-innovation link.
  • Corporate Governance and Ethical Behavior To improve corporate governance, watchdog groups advocate separating the chairperson and the chief executive positions and creating corporate boards that are dominated by outsiders. Here is where the S&P 500 currently stands in relation to this issue: • Fifteen instances where Chairperson is not CEO and is an Independent Director, 16 instances where Chairperson is not CEO and is an Outside Related Director, 65 instances where Chairperson is Former CEO, three instances where Chairperson is not CEO and is an Executive, six instances where Chairperson is not CEO and is a Former Executive, 392 instances (78%) where Chairperson is ALSO the CEO (CEO duality). Source : The Corporate Library. 2003. Exclusive special report on CEO/Chairman splits in the S&P 500: How Many and How Independent? (http://www.thecorporatelibrary. com/spotlight/boardsanddirectors/SplitChairs.html)
  • Ch11 Discussion Light

    1. 1. Corporate Governance Robert E. Hoskisson Michael A. Hitt R. Duane Ireland Chapter 11
    2. 2. Chapter 2 Strategic Leadership Chapter 4 The Internal Organization Chapter 6 Competitive Rivalry and Competitive Dynamics Chapter 9 International Strategy Chapter 1 Introduction to Strategic Management Chapter 3 The External Environment Chapter 5 Business-Level Strategy Chapter 8 Acquisition and Restructuring Strategies Chapter 11 Corporate Governance Strategic Intent Strategic Mission Chapter 7 Corporate-Level Strategy Chapter 10 Cooperative Strategy Chapter 12 Strategic Entrepreneurship Strategic Analysis Strategic Thinking Creating Competitive Advantage Monitoring And Creating Entrepreneurial Opportunities The Strategic Management Process
    3. 3. Discussion Questions <ul><li>What is corporate governance? What are the basic mechanisms that corporate shareholders employ to exercise corporate governance? </li></ul><ul><li>In an efficient separation between shareholder and managerial control, what roles do shareholders and top managers play? </li></ul><ul><li>But what problem does this separation create? </li></ul>Click Here Click Here Click Here More discussion questions Click Here
    4. 4. Discussion Questions (cont.) <ul><li>How does the agency problem relate specifically to diversification strategy? How does it relate to managerial risk taking in general? </li></ul><ul><li>How do governance devices (shareholder concentration, institutional shareholders, boards of directors and managerial compensation, and market for corporate control) relate to controlling the agency problem? Are there tradeoffs among these devices? </li></ul>Click Here Click Here Click Here More discussion questions
    5. 5. Discussion Questions (cont.) <ul><li>How does corporate governance differ in Germany and Japan? </li></ul><ul><li>How important is ethics in corporate governance? </li></ul>Click Here Click Here
    6. 6. Discussion Question 1 <ul><li>What is corporate governance? </li></ul><ul><li>What are the basic mechanisms that corporate shareholders employ to exercise corporate governance? </li></ul>
    7. 7. Corporate Governance <ul><li>Corporate governance is </li></ul><ul><ul><li>a relationship among stakeholders that is used to determine and control the strategic direction and performance of organizations </li></ul></ul><ul><ul><li>concerned with identifying ways to ensure that strategic decisions are made effectively </li></ul></ul><ul><ul><li>used in corporations to establish order between the firm’s owners and its top-level managers </li></ul></ul>
    8. 8. Corporate Governance Mechanisms <ul><li>Ownership concentration </li></ul><ul><ul><li>relative amounts of stock owned by individual shareholders and institutional investors </li></ul></ul><ul><li>Board of Directors </li></ul><ul><ul><li>individuals responsible for representing the firm’s owners by monitoring top-level managers’ strategic decisions </li></ul></ul>Internal Governance Mechanisms The Firm
    9. 9. Corporate Governance Mechanisms <ul><li>Executive Compensation </li></ul><ul><ul><li>use of salary, bonuses, and long-term incentives to align managers’ interests with shareholders’ interests </li></ul></ul><ul><li>Monitoring by top-level managers </li></ul><ul><ul><li>they may obtain Board seats (not in financial institutions) </li></ul></ul><ul><ul><li>they may elect Board representatives </li></ul></ul>Internal Governance Mechanisms The Firm
    10. 10. Corporate Governance Mechanisms <ul><li>Market for Corporate Control </li></ul><ul><ul><li>the purchase of a firm that is underperforming relative to industry rivals in order to improve its strategic competitiveness </li></ul></ul>External Governance Mechanisms Click Here Return to Discussion Questions The Firm The Firm
    11. 11. Discussion Question 2 <ul><li>In an efficient separation between shareholder and managerial control, what roles do shareholders and top managers play? </li></ul>
    12. 12. Separation of Ownership and Managerial Control <ul><li>Basis of the modern corporation </li></ul><ul><ul><li>shareholders purchase stock, becoming residual claimants </li></ul></ul><ul><ul><li>shareholders reduce risk by holding diversified portfolios </li></ul></ul><ul><ul><li>professional managers are contracted to provide decision-making </li></ul></ul><ul><li>Modern public corporation form leads to efficient specialization of tasks </li></ul><ul><ul><li>risk bearing by shareholders </li></ul></ul><ul><ul><li>strategy development and decision-making by managers </li></ul></ul>Return to Discussion Questions Click Here
    13. 13. Discussion Question 3 <ul><li>But what problem does this separation create? </li></ul>
    14. 14. Agency Relationship: Owners and Managers <ul><li>Firm owners </li></ul>Shareholders (Principals)
    15. 15. Agency Relationship: Owners and Managers <ul><li>Decision makers </li></ul><ul><li>Firm owners </li></ul>Managers (Agents) Shareholders (Principals)
    16. 16. Agency Relationship: Owners and Managers <ul><li>Risk bearing specialist (principal) pays compensation to </li></ul><ul><li>A managerial decision-making specialist (agent) </li></ul><ul><li>Decision makers </li></ul><ul><li>Firm owners </li></ul>An Agency Relationship Managers (Agents) Shareholders (Principals)
    17. 17. Agency Theory Problem <ul><li>The agency problem occurs when: </li></ul><ul><ul><li>the desires or goals of the principal and agent conflict and it is difficult or expensive for the principal to verify that the agent has behaved inappropriately </li></ul></ul><ul><li>Solution: </li></ul><ul><ul><li>principals engage in incentive-based performance contracts </li></ul></ul><ul><ul><li>monitoring mechanisms such as the board of directors </li></ul></ul><ul><ul><li>enforcement mechanisms such as the managerial labor market to mitigate the agency problem </li></ul></ul>Return to Discussion Questions Click Here
    18. 18. Discussion Question 4 <ul><li>How does the agency problem relate specifically to diversification strategy? How does it relate to managerial risk taking in general? </li></ul>
    19. 19. Manager and Shareholder Risk and Diversification Risk Diversification Dominant Business Unrelated Businesses Related Constrained Related Linked Managerial (employment) risk profile Shareholder (business) risk profile B S A M
    20. 20. Agency Theory Conflicts <ul><li>Principals may engage in monitoring behavior to assess the activities and decisions of managers </li></ul><ul><li>However, dispersed shareholding makes it difficult and inefficient to monitor management’s behavior </li></ul><ul><li>Boards of Directors have a fiduciary duty to shareholders to monitor management </li></ul><ul><li>However, Boards of Directors are often accused of being lax in performing this function </li></ul>Click Here Return to Discussion Questions
    21. 21. Discussion Question 5 <ul><li>How do governance devices (shareholder concentration, institutional shareholders, boards of directors and managerial compensation, and market for corporate control) relate to controlling the agency problem? Are there tradeoffs among these devices? </li></ul>
    22. 22. Governance Mechanisms <ul><li>Large block shareholders (often institutional owners) have a strong incentive to monitor management closely </li></ul><ul><li>Their large stakes make it worth their while to spend time, effort and expense to monitor closely </li></ul><ul><li>They may also obtain Board seats which enhances their ability to monitor effectively (although financial institutions are legally forbidden from directly holding board seats) </li></ul>Ownership Concentration
    23. 23. Governance Mechanisms <ul><li>Insiders </li></ul><ul><li>The firm’s CEO and other top-level managers </li></ul><ul><li>Related Outsiders </li></ul><ul><li>Individuals not involved with day-to-day operations, but who have a relationship with the company </li></ul><ul><li>Outsiders </li></ul><ul><li>Individuals who are independent of the firm’s day-to-day operations and other relationships </li></ul>Ownership Concentration Board of Directors
    24. 24. Governance Mechanisms <ul><li>Recommendations for more effective Board Governance: </li></ul><ul><ul><li>Increase diversity of board members’ backgrounds </li></ul></ul><ul><ul><li>Strengthen internal management and accounting control systems </li></ul></ul><ul><ul><li>Establish formal processes for evaluation of the board’s performance </li></ul></ul>Ownership Concentration Board of Directors
    25. 25. Governance Mechanisms <ul><li>Salary, bonuses, long term incentive compensation </li></ul><ul><li>Executive decisions are complex and non-routine </li></ul><ul><li>Many factors intervene making it difficult to establish how managerial decisions are directly responsible for outcomes </li></ul>Ownership Concentration Executive Compensation Board of Directors
    26. 26. Governance Mechanisms <ul><li>Stock ownership (long-term incentive compensation) makes managers more susceptible to market changes which are partially beyond their control </li></ul><ul><li>Incentive systems do not guarantee that managers make the “right” decisions, but do increase the likelihood that managers will do the things for which they are rewarded </li></ul>Ownership Concentration Executive Compensation Board of Directors
    27. 27. Governance Mechanisms <ul><li>Firms face the risk of takeover when they are operated inefficiently </li></ul><ul><li>Many firms begin to operate more efficiently as a result of the “threat” of takeover, even though the actual incidence of hostile takeovers is relatively small </li></ul><ul><li>Changes in regulations have made hostile takeovers difficult </li></ul><ul><li>Acts as an important source of discipline over managerial incompetence and waste </li></ul>Ownership Concentration Executive Compensation Market for Corporate Control Board of Directors
    28. 28. Managerial Defense Tactics <ul><li>Designed to fend off the takeover attempt </li></ul><ul><li>Increase the costs of making the acquisitions </li></ul><ul><li>Causes incumbent management to become entrenched while reducing the chances of introducing a new management team </li></ul><ul><li>May require asset restructuring </li></ul><ul><li>Institutional investors oppose the use of defense tactics </li></ul>Click Here Return to Discussion Questions
    29. 29. Discussion Question 6 <ul><li>How does corporate governance differ in Germany and Japan? </li></ul>
    30. 30. International Corporate Governance: <ul><li>Owner and manager are often the same in private firms </li></ul><ul><li>Public firms often have a dominant shareholder, frequently a bank </li></ul><ul><li>Frequently there is less emphasis on shareholder value than in U.S. firms, although this may be changing </li></ul>Germany
    31. 31. International Corporate Governance: <ul><li>Medium to large firms have a two-tiered board </li></ul><ul><ul><li>vorstand monitors and controls managerial decisions </li></ul></ul><ul><ul><li>aufsichtsrat selects the Vorstand </li></ul></ul><ul><ul><li>employees, union members and shareholders appoint members to the Aufsichtsrat </li></ul></ul>Germany
    32. 32. International Corporate Governance: <ul><li>Obligation, “family” and consensus are important factors </li></ul><ul><li>Banks (especially “main bank”) are highly influential with firm’s managers </li></ul><ul><li>Keiretsus are strongly interrelated groups of firms tied together by cross-shareholdings </li></ul>Japan
    33. 33. International Corporate Governance: <ul><li>Other characteristics: </li></ul><ul><ul><li>powerful government intervention </li></ul></ul><ul><ul><li>close relationships between firms and government sectors </li></ul></ul><ul><ul><li>passive and stable shareholders who exert little control </li></ul></ul><ul><ul><li>virtual absence of external market for corporate control </li></ul></ul>Click Here Return to Discussion Questions Japan
    34. 34. Discussion Question 7 <ul><li>How important is ethics in corporate governance? </li></ul>
    35. 35. Corporate Governance and Ethical Behavior <ul><li>In the U.S., shareholders (in the capital market stakeholder group) are viewed as the most important stakeholder group </li></ul><ul><li>which are served by the board of directors </li></ul><ul><li>Hence, the focus of governance mechanisms is on the control of managerial decisions to ensure that shareholders’ interests will be served </li></ul>It is important to serve the interests of the firm’s multiple stakeholder groups! Capital Market Stakeholders The Firm
    36. 36. Corporate Governance and Ethical Behavior It is important to serve the interests of the firm’s multiple stakeholder groups! <ul><li>Product market stakeholders (customers, suppliers and host communities) and organizational stakeholders (managerial and non-managerial employees) are also important stakeholder groups </li></ul>The Firm Product Market Stakeholders Capital Market Stakeholders
    37. 37. Corporate Governance and Ethical Behavior It is important to serve the interests of the firm’s multiple stakeholder groups! <ul><li>Although the idea is subject to debate, some believe that ethically responsible companies design and use governance mechanisms that serve all stakeholders’ interests </li></ul><ul><li>Importance of maintaining ethical behavior through governance mechanisms is seen in the example of Enron and Arthur Andersen </li></ul>The Firm Product Market Stakeholders Organizational Stakeholders Capital Market Stakeholders

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