Chapter 10: Corporate Governance
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Chapter 10
Corporate Governance
LEARNING OBJECTIVES
1. Define corporate governance and explain why it is used to monitor and control top-level
managers’ decisions.
2. Explain why ownership is largely separated from managerial control in organizations.
3. Define an agency relationship and managerial opportunism and describe their strategic
implications.
4. Explain the use of three internal governance mechanisms to monitor and control
managers’ decisions.
5. Discuss the types of compensation executives receive and their effects on managerial
decisions.
6. Describe how the external corporate governance mechanism—the market for corporate
control—restrains top-level managers’ decisions.
7. Discuss the nature and use of corporate governance in international settings, especially in
Germany, Japan, and China.
8. Describe how corporate governance fosters ethical decisions by a firm’s top-level
managers.
CHAPTER OUTLINE
Opening Case: The Corporate Raiders of the 1980s Have Become the Activist
Shareholders of Today
SEPARATION OF OWNERSHIP AND MANAGERIAL CONTROL
Agency Relationships
Product Diversification as an Example of an Agency Problem
Agency Costs and Governance Mechanisms
OWNERSHIP CONCENTRATION
The Increasing Influence of Institutional Owners
BOARD OF DIRECTORS
Enhancing the Effectiveness of the Board of Directors
Executive Compensation
The Effectiveness of Executive Compensation
Strategic Focus: Do CEOs Deserve the Large Compensation Packages They Receive?
MARKET FOR CORPORATE CONTROL
Managerial Defense Tactics
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INTERNATIONAL CORPORATE GOVERNANCE
Corporate Governance in Germany and Japan
Strategic Focus: “Engagement” vs. “Activist” Shareholders in Japan, Germany and
China
Corporate Governance in China
GOVERNANCE MECHANISMS AND ETHICAL BEHAVIOR
SUMMARY
KEY TERMS
REVIEW QUESTIONS
MINI-CASE: The Imperial CEO, JPMorgan Chase’s Jamie Dimon
ADDITIONAL QUESTIONS AND EXERCISES
MINDTAP RESOURCES
LECTURE NOTES
Chapter Introduction: The purpose of this chapter is to present and discuss how
shareholders (owners) can ensure that managers develop and implement strategic
OPENING CASE
The Corporate Raiders of the 1980s Have Become the Activist Shareholders of Today
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Teaching Note
The opening case is a great lesson to how effective corporate governance is necessary in
order for businesses to thrive. Ask the students how they would handle the situation if
they were the CEO of a company being raided. How would they handle the situation if
they were only a shareholder of the company being raided? Why are some of their
answers different when the goal of corporate governance is to do what is best for the
company overall and the stakeholders.
1
Define corporate governance and explain why it is used to
monitor and control top-level managers’ decisions.
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. At its core, corporate governance is concerned with identifying ways to ensure
that strategic decisions are made effectively.
Teaching Note
In the chapter, corporate governance is discussed from two perspectives:
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2
Explain why ownership is largely separated from
managerial control in organizations.
SEPARATION OF OWNERSHIP AND MANAGERIAL CONTROL
The growth of the large, modern public corporation is based primarily on the efficient
separation of ownership and managerial control.
Teaching Note
It is helpful to provide a story that would illustrate what the separation of ownership
and managerial control is all about, and how it came to be. For example, it is easy for
students to see that Henry Ford was involved in both the ownership and the operation
of Ford Motor Company in the early days. They can see in their minds the old footage
of Model T’s coming off a very crude assembly line, by today’s standards, and
understand how much simpler operations were at the time. That has all changed with
the advent of the modern, complex corporation. Today there is almost no way to bring
ownership and managerial control back together again in a workable model.
3
Define an agency relationship and managerial opportunism
and describe their strategic implications.
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Agency Relationships
FIGURE 10.1
An Agency Relationship
Note the following in the figure (Figure 10.1):
• Shareholders (principals) hire managers (agents) as decision makers.
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Product Diversification as an Example of an Agency Problem
Product diversification—discussed in Chapter 6—can be beneficial to both shareholders and
managers, but it also is a potential source of agency problems.
Managers may pursue higher levels of product diversification than are desired by
shareholders to capture the value of opportunities that are available to managers, but not to
owners.
Figure Note
Figure 10.2 illustrates the variance between the risk profiles of shareholders and
managers based on the level or type of firm diversification. It shows that owners
may benefit from managers’ decisions to diversify the firm’s products, but only to
the point where investment returns at the margin are no longer positive. That is,
diversification is valuable to (and preferred by) owners as long as it has a positive
effect on firm value. However, some firms may be over-diversified, despite the lack
of profitability in their dominant business. Owners also may prefer that excess
funds be returned to them in the form of dividends so they can control reinvestment
decisions.
FIGURE 10.2
Manager and Shareholder Risk and Diversification
Curve S represents the business or investment risk profile for shareholders (owners). It spans
a diversification scope from dominant business (which would be to the left of related-
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constrained) to a point between related-constrained and related-linked diversification. The
optimum risk level is at point A, between dominant business and related-constrained
diversification.
Agency Costs and Governance Mechanisms
The potential conflict illustrated by Figure 10.2, coupled with the fact that principals do not
know which managers might act opportunistically, demonstrates why principals establish
governance mechanisms.
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for continued investment in the stock market to facilitate growth. However, others argue that
the indirect costs are even more telling in regard to the impact on strategy formulation and
implementation.
Partly in response to governance breakdowns in the U.S., Congress enacted the Sarbanes-
Oxley (SOX) Act in 2002 and passed the Dodd-Frank Wall Street Reform and Consumer
Protection Act (Dodd-Frank) in 2010. Most believe that SOX has led to generally positive
outcomes in terms of protecting shareholders. Section 404 of SOX, for example, improves
transparency and internal controls and this, subsequently, increases shareholder value.
However, this resulted in increased costs to firms and a decrease in foreign firms listing on
U.S. stock exchanges.
4
Explain the use of three internal governance mechanisms to monitor and control managers’
decisions. .
OWNERSHIP CONCENTRATION
Ownership concentration is defined both by the number of large-block owners and by the
total percentage of the firm’s shares that they own.
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The Increasing Influence of Institutional Owners
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.
Teaching Note
Students should know about a few of the more common anti-takeover provisions. For
example, a golden parachute is a type of managerial protection that pays a guaranteed
salary for a specified period of time in the event of a takeover and the loss of one’s
job. A golden goodbye provides automatic payments to top executives if their
contracts are not renewed, regardless of the reason for nonrenewal. In the case of
acquisitions, managers may receive this compensation even if they voluntarily decide
to quit. Other defense strategies are described in greater detail in Table 10.2.
BOARD OF DIRECTORS
Even though institutional ownership has increased, the majority of firms still “enjoy” the
benefits or advantages of diffuse ownership (i.e., limited monitoring of managers by
individual shareholders). Furthermore, large financial institution shareholders—such as
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banks—are effectively prevented from having direct ownership of firms and are prohibited
from placing a representative on the boards of directors. These conditions highlight the
importance of boards of directors to corporate governance.
Table Note
Table 10.1 provides characteristics of three classifications of members of the board of
directors: insiders, related outsiders, and outsiders. These will be useful for students as
you discuss board effectiveness.
TABLE 10.1
Classifications of Board of Director Members
Insiders are represented by the firm’s CEO and other 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. Examples might include the firm’s legal
counsel, a large customer or supplier, or a close relative of one of the firm’s top–level
managers.
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Teaching Note
Outside directors (and boards) are perceived as ineffective because:
• Insiders dominate the board by limiting the flow of information to outside
directors.
• Outside directors are nominated for board membership by insiders (primarily by
the CEO) and thus are indebted to insiders.
Enhancing the Effectiveness of the Board of Directors
Because of the board’s importance, the performance of individual board members as well as
that of entire boards is being evaluated more formally and intensely.
Teaching Note
The following comments can be used to expand the class discussion of whether a
more active board is a more effective board. The findings from research regarding the
effectiveness of board involvement in the strategic decision-making process are
mixed, indicating the following:
• Board involvement in the strategic decision-making process may improve firm
performance because it provides the firm’s managers with access to outside
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opinions, and outside directors should be more objective and interested in
protecting owner interests.
Teaching Note
McKinsey & Co. research found that institutional shareholders were willing to pay an
Because of the increased pressure from owners and the potential conflict among board
members, procedures are necessary to help boards function effectively in facilitating the
strategic decision-making process.
Increasingly, outside directors are being required to own significant equity stakes as a
prerequisite to holding a board seat. In fact, some research suggests that firms perform better
if outside directors have such a stake.
5
Discuss the types of compensation executives receive and
their effects on managerial decisions.
Executive Compensation
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As illustrated in the opening case and Strategic Focus, the compensation of top-level
managers generates great interest and strongly held opinions. One reason for this widespread
interest can be traced to a natural curiosity about extremes and excesses. But furthermore,
CEO pay is an indirect but tangible way to assess governance processes in large corporations.
Teaching Note
When DaimlerBenz acquired Chrysler, it highlighted the fact that top executives at
Chrysler made much more than the executives at DaimlerBenz—but higher-paid
Chrysler executives report to lower-paid Daimler bosses. This example is one that
students seem to be able to grasp.
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Although incentive compensation plans may increase the value of a firm in line with
shareholder expectations, such plans are subject to managerial manipulation.
Although long-term performance-based incentives may reduce temptations to under-invest in
the short run, they increase executive exposure to risks associated with uncontrollable
events—e.g., market shifts, industry decline.
The Effectiveness of Executive Compensation
The compensation received by top-level managers, especially by CEOs, is often a subject of
controversy.
Teaching Note
One way that boards have found to compensate executives is through giving them
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Repricing stock options does not appear to be a function of management entrenchment or
ineffective governance. These firms often have had sudden and negative changes to their
growth and profitability. They also frequently lose their top managers.
Teaching Note
Board directors also receive compensation. Some recent figures follow:
• Median base compensation for directors in telecommunications was almost
$90,000.
• Directors at Microsystem Inc. received average compensation of about $410,000 a
year, whereas directors at Compaq earned over $360,000 and directors at Pfizer
received almost $260,000.
• On average, directors at the largest 200 firms received about $134,000.
• Similar to executives in the firm, there is a move by large institutional investors
such as CalPERS to pay directors at least partially in stock (some estimating that
some 50 percent of director pay will be in company stock).
STRATEGIC FOCUS
Do CEOs Deserve the Large Compensation Packages They Receive?
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increased, the shareholders’ best interests were not aligned with Zaslay’s goals, which did
not please the public.
Teaching Note: Ask the students if they believe that a company’s performance should be
directly related to the compensation of the CEO. Then dive deeper and ask which
performance indicators dictate the company’s performance, with the goal that the students
will realize that it is not a cut and dry issue. Then ask why restricted stock has become a
trend, and how it may be causing a societal problem.
6
Describe how the external corporate governance mechanism—
the market for corporate control—restrains top-level managers’
decisions.
MARKET FOR CORPORATE CONTROL
The market for corporate control generally comes into use as an external governance
mechanism only after internal governance mechanisms have failed.
A Brief History of the Market for Corporate Control
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The market for corporate control is an external governance mechanism that becomes active
when a firm’s internal controls fail. It is composed 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.
Managerial Defense Tactics
TABLE 10.2
Hostile Takeover Defense Strategies
This table presents a number of defense strategies and identifies them according to category
(preventive, reactive), popularity (high, medium, low, very low), effectiveness (high,
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medium, low, very low), and stockholder wealth effects (positive, negative, inconclusive).
The defense strategies mentioned are poison pill, corporate charter amendment, golden
parachute, litigation, greenmail, standstill agreement, and capital structure change.
Teaching Note: As mentioned throughout the chapter, internal and external
governance mechanisms, though they may restrain managerial actions, are imperfect
means of controlling managerial opportunism. This means that some combination of
both internal and external mechanisms is necessary.
7
Discuss the nature and use of corporate governance in
international settings, especially in Germany, Japan, and
China.
INTERNATIONAL CORPORATE GOVERNANCE
Corporate Governance in Germany and Japan