Chapter 10

Corporate Governance

Hitt, Ireland, and Hoskisson

Definition of corporate governance

 Corporate governance – the set of

mechanisms used
 to manage the relationship among stakeholders
and
 to determine strategic direction and
 control the performance of organizations.

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Internal governance mechanisms

 Three internal governance mechanisms

 ownership concentration
 the board of directors
 executive compensation.

 The market for corporate control is the single

external governance mechanism influencing
managers’ decisions and the outcomes
resulting from them.
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Ownership separation
 Modern corporations
are characterized by an
agency relationship that
is created when one
party (the firm’s
owners) hires and pays
another party (top-level
managers) to use its
decision-making skills.

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Separation of ownership and control

 Separation of ownership and control creates

an agency problem when an agent pursues
goals that conflict with principals’ goals.
 Principals establish and use governance
mechanisms to control this problem.

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Ownership concentration

 Ownership concentration is based on the

number of large block shareholders and the
percentage of shares they own.
 Institutional investors are an increasingly
powerful force in corporate America and
actively use their positions of concentrated
ownership to force managers and boards of
directors to make decisions that maximize a
firm’s value.

Copyright © 2008 Cengage

Boards of directors
 In the U.S. and the U.K., a firm’s board of directors
(composed of insiders, related outsiders, and
outsiders) is a governance mechanism expected to
represent shareholders’ collective interests.
 The percentage of outside directors on many boards
now exceeds the percentage of inside directors. The
SOX Act requires outsiders to be more independent
of a firm’s top-level managers compared with
directors selected from inside the firm.

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Executive compensation

 Executive compensation – including salary,

bonuses, and long-term incentives - is a
highly visible and often criticized governance
mechanism.
 The firm’s board of directors determines the
effectiveness of the firm’s executive
compensation system.

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Corporate control
 While shareholders and boards of directors may
have become more vigilant in their control of
managerial decisions, they are insufficient to govern
managerial behavior in many large companies.
 Therefore, the market for corporate control is an
important governance mechanism.
 Although corporate control is also imperfect, it has been
effective in causing corporations to combat inefficient
diversification and to implement more effective strategic
decisions.

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Corporate governances differ
globally
 Corporate governance structures differ in Germany,
Japan, and U.S.
 U.S. historically focused on maximizing shareholder value.
 Employees in Germany took a prominent role as
stakeholders.
 Japanese shareholders played virtually no role until
recently
 Now Japanese firms are being challenged by “activist”
shareholders.
 Internationally, systems in various countries are
becoming increasingly similar.

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Effective governance mechanisms
 Effective governance mechanisms ensure that the
interests of all stakeholders are served.
 Long-term strategic success results when firms are
governed in ways that permit satisfaction of
 capital market stakeholders (such as shareholders)
 product market stakeholders (such as customers and
suppliers)
 and organizational stakeholders (managerial and non-
managerial employees).
 Effective governance produces ethical behavior in
forming and implementing strategies.
Copyright © 2008 Cengage