Chapter 10
Corporate Governance
CHAPTER OVERVIEW
LEARNING OBJECTIVES
LECTURE NOTES
10-1 SEPARATION OF OWNERSHIP AND MANAGERIAL CONTROL
10-1a Agency Relationships
10-4 MARKET FOR CORPORATE CONTROL
10-4a Managerial Defense Tactics
10-5 INTERNATIONAL CORPORATE GOVERNANCE
10-5a Corporate Governance in Germany and Japan
10-5b Corporate Governance in China
Chapter 10: Corporate Governance
CHAPTER OVERVIEW
Chapter 10 covers many aspects of corporate governance, which is the relationship
between a firm and its stakeholders that is used to determine a firm’s direction and control
its performance. How firms monitor and control top-level managers’ decisions and actions
affects the implementation of strategies. Effective governance that aligns managers’
decisions with shareholders’ interests can help produce a competitive advantage for the
firm. This chapter looks at the three internal governance mechanisms used in the modern
corporation: ownership concentration, the board of directors, and executive
compensation.
In the second section of the chapter, students learn how shareholders influence and control
top-level managers’ decisions. Ownership concentration is based on the number of large–
block shareholders and the percentage of shares they own. With significant ownership
percentages, such as those held by large mutual funds and pension funds, institutional
investors often are able to influence top-level managers’ strategic decisions and actions.
Thus, unlike diffuse ownership, which tends to result in relatively weak monitoring and
Chapter 10: Corporate Governance
independent of a firm’s top-level managers compared with directors selected from inside
the firm. Additional governance-related regulations have resulted from the Dodd-Frank
Act.
In the chapter’s next section, students discover another external form of corporate
governance—the market for corporate control. In general, evidence suggests that
shareholders and boards of directors have become more vigilant in controlling managerial
decisions. Nonetheless, these mechanisms are imperfect and sometimes insufficient. When
the internal mechanisms fail, the market for corporate control becomes relevant. Although
it, too, is imperfect, the market for corporate control has been effective in improving
corporations’ diversification portfolios and implementing more effective strategic
decisions.
The chapter ends by tying corporate governance to the issue of ethics. Effective
governance mechanisms ensure that the interests of all stakeholders are served. Thus,
strategic competitiveness results when firms are governed in ways that permit at least
minimal satisfaction of capital market stakeholders (e.g., shareholders), product market
Chapter 10: Corporate Governance
LEARNING OBJECTIVES
1. Define corporate governance and explain why it is used to monitor and control top-level
managers’ decisions.
5. Discuss the types of compensation top-level managers receive and their effects on
managerial decisions.
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
decisions in the best interests of the shareholders (owners) and not be primarily self-
OPENING CASE
Shareholder Activists and Corporate Governance
The Opening Case introduces students to something called activist shareholders, which are
investment firms that buy up significant shares in an organization and then use that power
to strongly influence board and executive decisions within the firm. The number of these
activist firms is growing, as is the amount of money they’re investing in organizations
Chapter 10: Corporate Governance
Teaching Note
The Opening Case is a great lesson in 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 influenced by an activist firm. How would
they handle the situation if they were only a shareholder of the company? 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
Teaching Note
In the chapter, corporate governance is discussed from two perspectives:
• The primary purpose of governance mechanisms is to prevent severe problems that
Chapter 10: Corporate Governance
10–1 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.
Shareholders make investments by purchasing stock (representing ownership), which
entitles them to a share of the firm’s residual income (or profit) that remains after all
expenses have been paid.
• The right to share in residual income means that shareholders also must accept the risk that
no residual profits will remain if the firm’s expenses exceed its income.
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
control back together again in a workable model.
Chapter 10: Corporate Governance
10-1a Agency Relationships
Although the efficient separation of ownership and control enables specialization by
owners and managers, it also results in some potential costs (and risks) for owners by
creating an agency relationship.
An agency relationship exists when one party [the principal(s)] delegates decision making
Figure Note
FIGURE 10.1
An Agency Relationship
Note the following in Figure 10.1:
• Shareholders (principals) hire managers (agents) as decision makers.
An agency relationship enables the possibility of managerial opportunism, the seeking of
self-interest with guile (i.e., with cunning or deceit), where opportunism is represented by
an attitude or inclination and a set of behaviors.
10-1b 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.
• Increased diversification generally drives the growth of the firm, and firm growth is
positively related to managerial compensation. Thus, by diversifying to a greater extent
than may be desired by shareholders, managers may enjoy the higher levels of
compensation that accompany managing larger firms.
• Increased diversification also may provide managers with access to increased levels of
slack resources or free cash flows, resources that are generated after investment in all
internal projects that have positive net present values within the firm’s current product
lines. Managers may choose to invest excess funds in products or activities that are not
related to the firm’s existing core businesses and products if they perceive attractive
(positive net present value) investment opportunities.
Figure Note
Figure 10.2 illustrates the variance between the risk profiles of shareholders and
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-constrained) to a point between related-constrained and related-linked
Chapter 10: Corporate Governance
As illustrated by Curve S (owner business risk preference) and Curve M (managerial
employment risk preference), there is a conflict between owners and managers regarding
the desired levels of firm diversification and risk.
• Owners prefer that the scope be greater than a dominant business but less than related–
linked diversification.
STRATEGIC FOCUS
General Electric’s Complex Diversification Strategy Makes Evaluation Difficult for
Board Directors
General Electric (GE) is in a bind. Back in the 1980s and 1990s, former CEO Jack Welch
diversified GE in countless ways. But after the financial crisis of 2008, the next CEO,
Jeffrey Immelt, needed to address the significant problems that had resulted from excess
Chapter 10: Corporate Governance
Teaching Note
Ask students for their thoughts on the role of activist investors. Should they or
shouldn’t they have the power to change the CEO and other board members and to
influence the company’s direction?
10-1c 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.
Research suggests that a more intensive application of governance mechanisms may
produce significant changes in strategies. Corporate America needs more intense
governance in order for continued investment in the stock market to facilitate growth.
However, others argue that the indirect costs are even more telling regarding the impact on
strategy formulation and implementation.
Dodd-Frank is the most sweeping set of financial regulatory reforms in the United States
in almost a century. Dodd-Frank:
• Created a Financial Stability Oversight Council headed by the Treasury Secretary
Chapter 10: Corporate Governance
10–2 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.
Large-block shareholders are investors who typically own at least 5 percent of the firm’s
shares.
Diffuse ownership (a large number of shareholders with small holdings and few/no large-
10-2a The Increasing Influence of Institutional Owners
In recent years, large-block ownership by individuals has declined, but it has 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.
Chapter 10: Corporate Governance
Institutional investor BlackRock, Inc. has taken actions that illustrate the rising tide of
shareholder pressure.
• BlackRock, Inc. is the largest manager of financial assets in the world, with just under $6
trillion invested and holdings in most of the largest global corporations.
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
10–3 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
of boards of directors to corporate governance.
Teaching Note
Legally, the board of directors has broad powers, including:
• Directing the affairs of the organization
Chapter 10: Corporate Governance
The board of directors is a group of elected individuals whose primary responsibility is to
Table Note
Table 10.1 provides characteristics of three classifications of members of the board of
TABLE 10.1
Classification of Board of Directors’ 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
Teaching Note
Outside directors (and boards) are perceived as ineffective because:
• Insiders dominate the board by limiting the flow of information to outside directors.
The drawbacks of outside boards are as follows:
• Because outside directors do not have day-to-day contact with the ongoing operations of
Chapter 10: Corporate Governance
• In the absence of rich information, boards may have to emphasize financial rather than
10-3a 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.
Many boards have voluntarily initiated changes, including:
• Increasing the diversity of board members’ backgrounds
Teaching Note
Use the following comments to discuss 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, which indicates 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
opinions, and outside directors should be more objective and interested in
protecting owner interests.
Chapter 10: Corporate Governance
Teaching Note
McKinsey & Co. found that institutional shareholders were willing to pay an 11 percent
Research shows that boards working collaboratively with management:
• Make higher-quality strategic decisions
One activist concludes that boards need three foundational characteristics to be effective:
director stock ownership, executive meetings to discuss important strategic issues, and a
serious nominating committee that truly controls the nomination of new members.
5
Discuss the types of compensation top-level managers receive
and their effects on managerial decisions.
10-3b Executive Compensation
As illustrated in the Opening Case and Strategic Focus, the compensation of top-level
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.
Chapter 10: Corporate Governance
act in shareholders’ best interests. Alternatively, stockholders largely assume that top–
executive pay and the performance of a firm are more closely aligned when firms have
boards that are dominated by outside members.
Teaching Note
When DaimlerBenz acquired Chrysler, it highlighted the fact that top executives at
students seem to be able to grasp.
Developing and implementing an effective incentive compensation program is quite
challenging because:
• Strategic decisions made by top managers are complex and non-routine. Due to difficulties
in judging decision quality, compensation is often linked to more measurable outcomes
such as financial performance.
Although incentive compensation plans may increase the value of a firm in line with
shareholder expectations, such plans are subject to managerial manipulation.
10-3c The Effectiveness of Executive Compensation
The compensation received by top-level managers, especially by CEOs, is often a subject
of controversy.
Chapter 10: Corporate Governance
Furthermore, a review of the research suggests that over time, firm size has accounted for
more than 50 percent of the variance in total CEO pay, whereas firm performance has
accounted for less than 5 percent of the variance.
Teaching Note
Boards can compensate executives by giving them loans with favorable or zero interest
Annual bonuses may provide incentives to pursue short-run objectives at the expense of
the firm’s long-term interests.
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.
Chapter 10: Corporate Governance
Teaching Note
Board directors also receive compensation. Some recent figures follow:
• Median base compensation for directors in telecommunications was almost
$90,000.
6
Describe how the external corporate governance mechanism—the
market for corporate control—restrains top-level managers’ decisions.
10-4 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: A Mini-Lecture
The market for corporate control has been active for some time. The 1980s was a
time of merger mania, with around 55,000 acquisitions valued at approximately
$1.3 trillion. However, there were many more acquisitions in the 1990s, and the
Chapter 10: Corporate Governance
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 to
form a new division in an established diversified firm, merge two previously separate
STRATEGIC FOCUS
Has More Governance Scrutiny Made Large CEO Compensation Packages More
Reasonable?
The Dodd-Frank Act of 2010 now requires companies to publish how much their CEOs
Teaching Note
Guide students in discussing the pros and cons of executive compensation, given that
the ratio of CEO-to-median-worker-pay is 140 to 1. Encourage students to look at both
10-4a Managerial Defense Tactics
Because of the threat of dismissal, managers have devised a number of defensive tactics
Chapter 10: Corporate Governance
• Managerial pay interventions, such as golden parachutes
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, medium, low, very low), and stockholder wealth effects (positive, negative,
The market for corporate control also can be plagued by inefficiency. In the 1980s,
roughly 50 percent of all takeovers targeted firms that were high performers. As a result:
• Acquisition prices were excessive
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.