Corporate governance determines how companies are directed and controlled. It has strategic and ethical implications. Bad governance leads to bad strategy and failure to meet responsibilities. Key issues include aligning manager and shareholder interests through compensation and boards, and including non-shareholder stakeholders. Future trends may include greater transparency, board accountability, and stakeholder involvement in governance.

1. Corporate governance: Why it
matters for strategy and ethics
Harry J. Van Buren III
Anderson School of Management
University of New Mexico

2. Corporate governance: What is it and
why does it matter?
• Corporate governance represents the
relationship among stakeholders that is used
to determine and control the strategic
direction and performance of organizations.
• Corporate governance has both strategic and
ethical implications.

3. Strategic implications of corporate
governance
• Simply put, bad corporate governance leads to
bad strategy formulation and implementation.
• If strategy is about matching the firm’s internal
resources and capabilities with opportunities
from the external environment, then corporate
governance should ask the following sorts of
questions…

4. Strategic implications of corporate
governance (2)
1. Do we have the right strategy, given what we do well?
2. Is our strategy matched to the external environment
(economy, social expectations, etc.)?
3. Are we capable of executing the strategy?
4. Do we have the right top management team?
5. If the answer to one or more of these questions is “no,” what
do we need to change?

5. Strategic implications of corporate
governance (3)
Bad strategy makes it harder for firms to
fulfill their economic and ethical
responsibilities to stakeholders, including
shareholders and employees!

6. Ethical issues in corporate governance
There are several key strategic and ethical
issues in corporate governance, including
• how to align the interests of top managers
and shareholders,
• the proper level and function of executive
compensation,
• who monitors the top management team and
how that monitoring occurs, and
• inclusion of shareholders and non-
shareholder stakeholders.

7. Aligning the interests of shareholders
and managers
One of the primary issues in corporate
governance is how to align the interests of
shareholders and managers.
– While most people don’t object to high levels of
pay for top managers (such as CEOs and
CFOs), they expect pay to be connected to
performance and stock price.

8. Why do we need to align the interests of
shareholders and managers?
At one time in U.S. history, firms were owned and
managed by founders and their descendents. As
firms grew larger, they needed more capital than
could easily be provided by one person or family,
and so the public corporation became more
common.

9. Why do we need to align the interests of
shareholders and managers? (2)
Corporations have two important virtues:
• They allow shareholders (investors) to reduce risk by
limiting their liability to the value of their investment.
• They allow shareholders to buy and sell their
ownership interests easily.
But there is a big problem that creates a potential
misalignment of interests between shareholders
and managers:
The Separation of Ownership and Control!

10. Why do we need to align the interests of
shareholders and managers? (3)
• Managers have day-to-day control of the company. The top
management team, for example, is in charge of things such
as strategy, hiring and firing employees, and so on.
• Shareholders don’t “own” the corporation in the same way
that you own your car: they don’t have physical possession
of a part of the corporation. Rather, what they own is a
limited set of decision rights, the right to share financially in
the company’s success, and a pro-rata share of the
company after all of its debts are paid if the company is
liquidated.

11. Why do we need to align the interests of
shareholders and managers? (4)
The separation of ownership and control leads to a
principal-agent relationship.
• The principal directs the activities of the agent.
• The agent acts on behalf of the principal, based on
the principal’s direction. The agent owes a duty of
loyalty to the principal.
For public corporations, shareholders are principals
and managers are agents; an agency problem exists
when agents have incentives to act in ways that are
contrary to the interests of their principals.

12. Why do we need to align the interests of
shareholders and managers? (5)
What makes agency problems particularly likely in
public corporations is the large number of ever-
changing principals (shareholders holding their stock
for varying periods of time), all of whom would be
better off if some shareholders would monitor the firm’s
managers.
Less monitoring of managers by shareholders than is
optimal occurs because monitoring is costly, but all
shareholders benefit from the actions of the few that
engage in monitoring (the free-rider problem). Think of
it this way: Would you always behave perfectly if no
one was watching you?

13. How do top managers misbehave?
Because of agency problems, managers have
incentives to do things that benefit themselves at
the expense of shareholders and other
stakeholders (too high compensation, over-
diversification, mergers, etc.).

14. Alignment Mechanism 1
Executive compensation
• The average compensation of a Fortune 500 CEO in 2007
was 364 times that of the average worker. An Economic Policy
Institute study found that between 1989 and 2007, CEO pay
increased by 163 percent, compared with only 10 percent for
the average worker (both adjusted for inflation).
• A number of studies have found that there is no correlation
between executive compensation and firm performance, and
recent work by Erickson, Hanlon, and Maydew (2003) found
that executive compensation plans weighted more heavily
toward stock compensation were related to the incidence of
accounting fraud.

15. Alignment mechanism 1
Executive compensation (2)
• There is evidence that (1) top managers have
too much influence on setting their own pay and
(2) boards have not done a good job of
connecting executive compensation to
performance (however performance is defined).
• Recent scandals involving insider trading have
added to cynicism about business, and pay that
is too high relative to performance may make the
company a target of criticism.

16. Alignment mechanism 1
Executive compensation (3)
• Good executive compensation plans take into account a
variety of strategic and financial indicators and then
reward for superior performance relative to industry
peers, rather than absolute levels of stock performance.
• In the absence of good information about a corporation’s
performance and strategies, shareholders and other
stakeholders are unable to adequately evaluate top-
manager performance—and over-compensation of top
managers is a likely result.

17. Alignment mechanism 2
Boards of directors
• Remember that shareholders are not in charge
of the day-to-day operations of a corporation.
Rather, they elect directors who then hire
managers charged with formulating and
implementing the company’s strategy.
• However, shareholders have little control over
who is nominated to the board of directors. Only
under very limited circumstances can they even
nominate a minority of the company’s directors.

18. Alignment mechanism 2
Boards of directors (2)
• As a result, members of a company’s board of
directors may feel more beholden to the CEO and the
top management team than to the shareholders in
whose interests they are supposed to be acting.
• Boards should be focused on evaluating the
organization’s (strategic and financial) performance
and firing top managers when that performance is
substandard and unlikely to improve.

19. Alignment mechanism 2
Boards of directors (3)
• Boards should also have a respectful
relationship with the top management team,
think of themselves as independent from the
CEO, and evaluate their own performance on a
regular basis. Such boards do a better job of
protecting shareholder value.

20. Alignment mechanism 3
The market for corporate control
• When a company is perceived to be financially
undervalued, there is the possibility that it can be
taken over (often through a hostile takeover).
When this happens, there is often a new
management team and strategy put into place.
• Some observers propose that the threat of being
taken over if the corporation is underperforming—
what is called the market for corporate control—
provides an additional means of aligning the
interests of shareholders and managers.

21. The role of institutional failures in
corporate governance
• Many of the well-known corporate-governance failures
are due to widespread institutional failures, including
failures by regulators, accounting firms, and financial
analysts. Take one of these failures out of the equation,
and perhaps some of the problems observed in the last
ten years might not have occurred.
• In particular, the incentive structures of accounting firms
and financial analysts caused many of them not to
provide appropriate oversight and criticism of corporate
managers. In the absence of effective monitoring of
managers, bad things tend to happen to companies.

22. Including non-shareholder stakeholders in
corporate governance
• Ethicists argue that although non-shareholder
stakeholders do not get to vote like shareholders do
(and as was noted before, that vote is limited in its
scope), their interests should be taken into account in
corporate governance processes.
• Companies, managers, and boards that take a long-
term view of the organization’s strategy might want to
consider the interests of non-shareholder stakeholders
very directly, as they can affect (positively or
negatively) the organization’s ability to create value for
shareholders.

23. Ethical duties managers and boards owe
shareholders
• Accurate and timely information about the
corporation’s performance and business
prospects, so shareholders can make
informed decisions about their investments.
• Best efforts to enhance shareholder wealth
• Avoidance of self-serving behavior.

24. A final comment. . .
It’s pretty apparent that many boards have
failed to do their jobs. That said,
shareholders and non-shareholder
stakeholders have a role to play in corporate
governance—and part of the blame for
recent corporate governance debacles rests
with them. Shareholders should demand
more of managers and boards.

25. What’s likely to happen with corporate
governance in the future?
1) Greater expectations for transparency in
financial and social reporting.
2) Increased expectations for board
involvement in strategy setting and
developing responses to social issues.

26. The role of government, accounting firms,
and other parties
• Bills like the Sarbanes-Oxley Act of 2003
represent attempts to deal with inherent
agency problems and conflicts of interest (on
the latter, issues like auditor independence).
Boards and senior managers are much more
accountable for the accuracy of their financial
reporting than before.

27. What’s likely to happen with corporate
governance in the future? (2)
3) Greater involvement by institutional
shareholders (pension funds, mutual
funds) in corporate governance processes.
4) Greater oversight of corporate boards and
managers by regulators, shareholders,
and non-shareholder stakeholders.