Theranos Case and Corporate Governance Principles

Chapter 12: Corporate Governance
and Business Ethics

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Chapter 12: Case Highlight:
Theranos: Bad Blood
Theranos:
• Medical diagnostic company
• Product: miniaturized lab that could run 200 diagnostic
tests from a single drop of blood
• Drew a lot of media hype, firms began to invest
• Grew to $5 billion in stock, and 800 employees
2

Chapter 12: Case Highlight:
Theranos: Bad Blood
Issues once the product was released in the market:
• FDA approval was not obtained
• Samples were shipped to California and analyzed there
• Lab results turned out to be inaccurate
Current state:
• Patients went back to traditional methods
• Elizabeth Holmes is scheduled to be
prosecuted for fraud
3

The Public Stock Company:
Four Benefits
• Limited liability for investors
• Transferability of investor ownership
– Through the trading of shares of stock on exchanges
• Legal personality
– Has legal rights and obligations
• Separation of legal ownership
and management control
4

Hierarchy of Authority
5
Exhibit 12.1

Alternative Team Production Theory of Corporate Law
Blair and Stout (1999) Virginia Law Review
6

Milton Friedman’s Philosophy
• “The social responsibility of business is to increase its
profits.”
• A survey asked the top 25 percent of income earners
holding a university degree in each country surveyed
whether they agree with Milton Friedman’s philosophy.
• The results…
7

Percent of “Informed Public” Who “Strongly or
Somewhat Agree” with Milton Friedman
8
Exhibit 12.2
SOURCE: Author’s depiction of data from Edelman’s (2011) Trust Barometer as included in “Milton
Friedman goes on tour,” The Economist, January 27, 2011.

Creating Shared Value
• Michael Porter maintains that executives should not
concentrate exclusively on increasing firm profits.
• Rather, the strategist should focus on creating shared
value, a concept that involves:
– Creating economic value for shareholders
– Creating social value by addressing society’s needs
and challenges
9

The Shared Value Creation Framework
• A model proposing that managers have a dual focus on:
– Shareholder value creation
– Value creation for society
• Example: GE’s “ecomagination” initiative
– To provide cleaner and more efficient sources of energy
– To provide abundant sources of clean water anywhere
in the world
– To reduce emissions
10

Michael Porter’s Recommendations to
Reconnect Economic and Societal Needs
1. Expand the customer base
– Bring in non-consumers such as those at the bottom
of the pyramid (large / poor socioeconomic group).
2. Expand traditional internal firm value chains
– Include more nontraditional partners such as
nongovernmental organizations (NGOs).
3. Focus on creating new regional clusters:
– Such as Silicon Valley in the United States
– Electronic City in Bangalore, India
– Chilecon Valley in Santiago, Chile
11

The Pyramid of Corporate Social Responsibility
12–12

Corporate Governance
• Corporate governance
 Mechanisms to direct and control a firm
 Ensure the pursuit of strategic goal
 Address the principal–agent problem
• When corporate governance failed
 Accounting scandal (Enron, WorldCom, Tyco …)
 Global financial crisis (housing bubble bursts)
 Bernard Madoff  Ponzi scheme
 “Made off” with the money!
• Information asymmetry
 Insider information
12–14

Corporate Governance
• Corporate governance represents the
relationship among stakeholders that is used to
determine and control the strategic direction and
performance of organizations.
 “Governance is the means by which to infuse order,
thereby to mitigate conflict and realize mutual gains.”
 Williamson, Oliver E. (2005), American Economic Review
• Agency costs are the sum of incentive costs,
monitoring costs, enforcement costs, and
individual financial losses incurred by principals
because it is impossible to use governance
mechanisms to guarantee total compliance by the
(risk-averse) agent.
12–15

The Role of Corporate Governance
• To provide mechanisms to:
– Direct and control an enterprise
– Ensure that it pursues strategic goals successfully and
legally
• To offer checks and balances
• To ask the tough questions when needed
• Attempts to address the principal-agent problem
16

The Principal-Agent Problem
17
Exhibit 12.3

Agency Theory
• A theory that views the firm as a nexus of legal contracts
– So conflicts that arise should be resolved legally.
– Therefore, the firm needs to design work tasks, incentives,
and employment contracts
• To minimize opportunism by agents
• Governance mechanisms should be put in place
to overcome two agency problems:
– Adverse selection
– Moral hazard
18

Adverse Selection and Moral Hazard
• Both problems are caused by information asymmetry
• Adverse Selection (market for lemons)
– Increases the likelihood of selecting
inferior alternatives (“ex ante” problem)
• Moral Hazard
– Increases the incentive of one party to take undue risks
or shirk other responsibilities (“ex post” problem)
– The costs incur to the other party
19

Agency Problems
• Berle and Means in The Modern Corporation
inquired whether we have “any justification for
assuming that those in control of a modern
corporation will also choose to operate it in the
interests of the stockholders?” (1932: p. 121)
• What are the corporate governance mechanism
that lessen the problem of the separation of
(shareholder) ownership (the risk-bearing
principals) from control (the managerial
decision-making agents)?
12–20

Corporate governance mechanisms to lessen the agency
problem of the separation of ownership from control
1. Internal control of Multidivisional;
--- “miniature capital market”
2. Debt (minimize free cash flow; e.g., LBOs);
3. Recruitment of executives from outside the firm;
4. Compensation heavily weighted toward stock options;
5. Takeovers (the market for corporate control)
6. Monitoring by institutional investors;
7. Financial statement auditors, government regulators,
and industry analysts;
8. Separate Chairperson and CEO; and
9. The Board of Directors

Strategy Highlight 12.1
HP’s Boardroom Drama
HP has lost its place in the world’s technology companies
• 80% market value drop between 2010 and 2012
• Formerly was admired for its corporate culture, the “HP Way”
Series of organizational drama in the board:
• A board member leaked a portion of the company’s strategy.
• The president of the company received a harassment lawsuit
and was forced to resign.
• The next CEO made an overvalued acquisition and was let go.
• Meg Whitman was the next CEO, and had to
cut 55,000 jobs to stay competitive
22

HP’s Boardroom Drama
HP has been split into two firms:
• HP Inc.: consumer hardware, PCs, and printers.
• Hewlett Packard Enterprise: business equipment and services.
23

Corporate governance mechanisms to lessen the agency
problem of the separation of ownership from control
Let’s review the following governance mechanisms in
more detail:
• The board of directors
• Executive compensation
• The market for corporate control
• Financial statement auditors,
government regulators, and
industry analysts
24

The Board of Directors
• The centerpiece of corporate governance
– Helps overcome the principal-agent problem
• Usually consist of inside and outside directors
– Inside directors: usually consist of: CEO, COO, CFO
– Outside directors: senior execs from other firms
• Elected by the shareholders
– Shareholder votes determine who is elected to the board
25

Responsibilities of the Board of Directors
• Strategic oversight and guidance
• CEO Selection, evaluation, compensation, and succession
• Provide guidance for executive compensation
• Review, monitor, evaluate, and approve strategic initiatives
– Such as large acquisitions
• Risk assessment and mitigation
• Ensure financial statements are accurate
26

GE’s Board of Directors
•GE’s board consists of:
– Members of companies, academia, and government
– 16 members, 5 different committees
•They meet about 12 times annually
•25% of the board are women (more than usual)
– Generally, the larger the company, the greater its
gender diversity.
– Diverse boards are less likely to fall victim to groupthink.
27

Executive Compensation
• Stock options are often part of compensation.
• The average ratio of CEO to employee pay is 300:1.
• About 2/3 of CEO pay is linked to firm performance.
– But this link is weak;
– Can further increase job stress; and
– Can negatively impact job performance
28

The Market for Corporate Control
• An external corporate-governance mechanism
• Consists of activist investors who:
– Seek to gain control of an underperforming corporation
– Buy shares of its stock in the open market
• Often pursued when a company is underperforming
– Sometimes corporate raiders breach trust
with other stakeholders (e.g., eliminate
defined pension plans)
29

Auditors, Government Regulators, and Industry Analysts
• Serve as additional external-governance mechanisms
• To avoid misrepresentation of financial results:
– Public financial statements must follow GAAP:
• Generally accepted accounting principles
– Financial statements must be audited
• By certified public accountants
• Industry analysts often base their buy, hold, or sell
recommendations on:
– Financial statements filed with the SEC
– Business news (WSJ, Forbes, CNBC, etc.)
30

Corporate Governance Around the World
• Difference in national institutions and culture
• “Free” market economies?
 State-directed capitalism (less freedom). Example:
China
 Free market capitalism (more freedom). Example: U.S.
• Germany
 Stakeholder capitalism
• France
 Stakeholder capitalism
• China
 State-owned enterprises
12–31

VW’s Dieselgate: School of Hard NOx
VW used to have a strong reputation
• Cars were known for highly reliable engines
Dieselgate was corporate fraud
• Corners were cut
• Defeat devices sensed when cars were
being tested for emissions and were
programmed to give false readings
32

VW’s Dieselgate: School of Hard NOx
Results of Dieselgate:
• Share price dropped by 30%.
• Senior executives were replaced, or prosecuted.
• VW had to repurchase or retro-fit all of the vehicles.
• Cost was over $25 billion in fines
as well as reputation loss.
33

Who is in Charge?
Blair, Margaret and Lynn Stout (1999). “A Team Production
Theory of Corporate Law,” Virginia Law Review, 85: 247-328.
• Who owns the corporation? “The shareholders do,” say most
economists and legal scholars. The dominant view is that public
corporations are bundles of resources collectively owned by
shareholders (principals) who hire directors and officers (agents)
to manage those resources in their behalf. This principal-agent
model has given rise to two recurring themes: First, that the
central economic problem addressed by corporate law is reducing
“agency costs” by focusing directors and managers on serving
shareholders’ interests; and second, that the primary goal
of the public corporation is – or ought to be – maximizing
shareholder wealth
The Shareholder Value Myth (Stout, 2012)

Who is in Charge?
1. The Principal-Agent Model
This model considers the firm as a nexus of explicit contracts
and examines it from an (ex ante) complete contracting
perspective. This view holds that the only residual claimants are
shareholders; therefore, only they warrant the control rights to
make decisions. This is the economic basis of shareholder
supremacy. This model has been the dominant view in legal
scholarship. It provides the rationale for the board of directors,
acting as the shareholders’ agents, to ensure that the officers
run the firm for the sole purpose of maximizing shareholders’
wealth
(Hansmann and Kraakman, 2001)

Who is in Charge?
1. The Principal-Agent Model and
The Conventional View of the Public Corporation

Who is in Charge?
Team Production Model of a public corporation:

Who is in Charge?
A Directors’ Legal Rule: Trustees More than Agents
From a legal perspective asserting that directors are share-
holders’ agents is a misleading description of the relationships
among directors, shareholders, and the public corporation.
Clark (1985) notes that:
Corporate officers are agents of the corporation itself;
The board of directors is the ultimate decision-maker of
the corporation;
Neither officers nor directors are agents of the
shareholders;
Both are “fiduciaries” with respect to the
corporation and its stockholders.
Thus, corporate directors are not agents in any legal
sense. They are not under the direct control of anyone,
including the shareholders who elected them.

Who is in Charge?
Directors’ Legal Role: Trustees More than Agents
Shareholders can elect directors and, under some
circumstances, remove them – but they cannot tell the directors
what to do.
Directors most closely resemble trustees in that they are
allowed free rein to make tradeoffs between the conflicting
interests of different corporate constituencies. American law
grants directors broad discretion to sacrifice shareholders’
interests in favor of those of management, employees, and
creditors in deciding what is best for “the corporation.”
This broad delegation of authority is both explained and
supported by the mediating hierarchy model because
subjecting the board to the direct command and control of one
or more constituencies would discourage team-specific
investments by the other stakeholders. 39

Who is in Charge?
Directors’ Legal Role: Trustees More than Agents
As early as the 1930s, the conflict between shareholder primacy
and the emerging stakeholder approach was highlighted in a
famous debate in the Harvard Law Review between two
prominent legal scholars, Adolf A. Berle (Columbia Law School)
and E. Merrick Dodd (Yale Law School) advocating these
opposing views.
Looking back on this debate, Berle (1954) conceded that “the
argument has been settled (at least for the time being) squarely
in favor of Professor Dodd’s contention,” and, as a matter of law,
“[corporate] powers [are] held in trust for the entire community.”

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