Topic 10 Corporate Governance

CHAPTER
10
Corporate Governance
Hitt, Ireland, Hoskisson, Strategic Management: Competitiveness & Globalization: Concepts & Cases, 13e. © 2020 Cengage.
All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or part.
LEARNING OBJECTIVES (slide 1 of 2)
Studying this chapter should provide you with the strategic
management knowledge needed to:
10-1 Define corporate governance and explain why it is used to
monitor and control top-level managers’ decisions.
10-2 Explain why ownership is largely separated from managerial
control in organizations.
10-3 Define an agency relationship and managerial opportunism and
describe their strategic implications.
10-4 Explain the use of three internal governance mechanisms to
monitor and control managers’ decisions.
10-5 Discuss the types of compensation top-level managers receive
and their effects on managerial decisions.
LEARNING OBJECTIVES (slide 2 of 2)
Studying this chapter should provide you with the strategic
management knowledge needed to:
10-6 Describe how the external corporate governance mechanism—
the market for corporate control—restrains top-level managers’
decisions.
10-7 Discuss the nature and use of corporate governance in
international settings, especially in Germany, Japan, and China.
10-8 Describe how corporate governance fosters ethical decisions by
a firm’s top-level managers.
Chapter Introduction (slide 1 of 2)
• Corporate governance is the set of mechanisms used
to manage the relationships among stakeholders and to
determine and control the strategic direction and
performance of organizations.
• Corporate governance:
• Is an increasingly important part of the strategic management
process
• Is concerned with identifying ways to ensure that decisions
(especially strategic decisions):
• Are made effectively
• Facilitate a firm’s efforts to achieve strategic competitiveness
• Can be thought of as a means to establish and maintain
harmony between a firm’s owners and its top-level managers
Chapter Introduction (slide 2 of 2)
• Effective governance that aligns managers’ decisions
with shareholders’ interests can help produce a
competitive advantage for the firm.
• Three internal governance mechanisms are used in the
modern corporation:
1. Ownership concentration (represented by types of shareholders
and their different incentives to monitor managers)
2. The board of directors
3. Executive compensation
• The market for corporate control is an external
governance mechanism influencing managers’ decisions
and the outcomes resulting from them.
10-1 Separation of Ownership
and Managerial Control (slide 1 of 2)
• Except in a number of small firms and family-
owned firms, ownership is separated from
control in the modern corporation.
• Supporting the separation is a basic legal premise
suggesting that the primary objective of a firm’s
activities is to increase the corporation’s profit and,
thereby, the owners’ (shareholders’) financial gains.
10-1 Separation of Ownership
and Managerial Control (slide 2 of 2)
• The separation of ownership and managerial
control allows shareholders to purchase stock,
which entitles them to income (residual returns)
from the firm’s operations after paying expenses.
• This right requires that shareholders take a risk that
the firm’s expenses may exceed its revenues.
• To manage this investment risk, shareholders maintain a
diversified portfolio by investing in several companies to
reduce their overall risk.
10-1a Agency Relationships (slide 1 of 2)
• Modern corporations are characterized by an agency
relationship between owners and managers.
• An agency relationship exists when one party delegates
decision-making responsibility to a second party for
compensation.
• The agency relationship between owners and managers works
as follows:
• Owners (principals) hire managers (agents) to make decisions that
maximize the firm’s value.
• As risk-bearing specialists, owners diversify their risk by investing in
multiple corporations with different risk profiles.
• Owners expect their agents (the firm’s top-level managers, who are
decision-making specialists) to make decisions that will help to
maximize the value of their firm.
Figure 10.1
An Agency Relationship
10-1a Agency Relationships (slide 2 of 2)
• The separation between ownership and managerial control can
create problems.
• The principal and the agent may have different interests and goals.
• The agent may make decisions that result in pursuing goals that conflict
with those of the principal.
• These divergent interests and goals between principals and agents
may lead to managerial opportunism.
• Managerial opportunism is the seeking of self-interest with guile (i.e.,
cunning or deceit).
• Managerial opportunism prevents the maximization of shareholder
wealth.
• Principals establish governance and control mechanisms to prevent
agents from acting opportunistically.
10-1b Product Diversification as an
Example of an Agency Problem (slide 1 of 3)
• Product diversification is a potential agency problem that
could result in principals incurring costs to control their
agents’ behavior.
• Product diversification can create two benefits for top-
level managers that shareholders do not enjoy.
1. Top-level managers can increase their compensation.
• Product diversification usually increases the size of a firm, and size
is positively related to executive compensation.
2. Managerial employment risk—the risk of job loss, loss of
compensation, and loss of managerial reputation—can be
reduced.
• Increased diversification reduces managerial employment risk
because a firm and its upper-level managers are less vulnerable to
the reduction in demand associated with a single or limited number
of product
Hitt, Ireland, lines
Hoskisson,or businesses.
Strategic Management: Competitiveness & Globalization: Concepts & Cases, 13e. © 2020 Cengage.
• Free cash flow—the cash remaining after the firm has
invested in all projects that have positive net present
value within its current businesses—is the source of
another potential agency problem.
• To increase the firm’s degree of diversification, top-level
managers may decide to invest free cash flow in product lines
that are not associated with the firm’s current lines of business
and do not have a strong possibility of creating additional value
for shareholders.
• Shareholders may prefer that free cash flow be distributed to
them as dividends or stock buybacks, so they can control how
the cash is invested.
• Both principals (owners) and agents (managers)
seek different optimal levels of diversification.
• As the firm’s owners, shareholders seek the level of
diversification that reduces the risk of the firm’s total
failure while simultaneously increasing its value by
developing economies of scale and scope.
• Managers prefer a higher level of diversification, but
only to a level that falls short of the point at which it
increases their employment risk and reduces their
employment opportunities.
Figure 10.2
Manager and Shareholder Risk and Diversification
10-1c Agency Costs and
Governance Mechanisms (slide 1 of 2)
• Agency costs are the sum of incentive costs, monitoring costs,
enforcement costs, and individual financial losses incurred by
principals because governance mechanisms cannot guarantee total
compliance by the agent.
• Principals’ agency costs are larger in diversified firms due to the
additional complexity of diversification.
• The effects of governance mechanisms are influenced by how weak
or strong they are.
• When governance mechanisms are weak and ineffective, managerial
interests may prevail, such as in situations where managers have a
significant amount of autonomy to make strategic decisions.
• If strong governance mechanisms are used, such as a board of
directors controlling managerial autonomy, the firm’s strategies should
better reflect stakeholders’ interests.
10-1c Agency Costs and
Governance Mechanisms (slide 2 of 2)
• In recent years, corporate governance
mechanisms have received greater scrutiny due
to the passing of:
• The Sarbanes-Oxley Act (S O X) of 2002
• The Dodd-Frank Wall Street Reform and Consumer
Protection Act (Dodd-Frank) of 2010
10-2 Ownership Concentration
(slide 1 of 2)
• Ownership concentration is defined by the

number of large-block shareholders and the total
percentage of the firm’s shares they own.
• Large-block shareholders typically own at least 5
percent of a company’s issued shares.
• Large-block shareholders are increasingly active in their
demands that firms adopt effective governance mechanisms
to control managerial decisions so that they will best
represent owners’ interests.
• In recent years, the number of large-block shareholders has
declined.
• Institutional owners have replaced individuals as large-block
shareholders.
10-2 Ownership Concentration
(slide 2 of 2)
• Ownership concentration influences decisions

made about the strategies a firm will use and the
value created by their use.
• In general, diffuse ownership (a large number of
shareholders with small holdings and few, if any,
large-block shareholders) produces weak monitoring
and control of managerial decisions.
• With high degrees of ownership concentration, the
probability is greater that managers’ decisions will be
designed to maximize shareholder value.
10-2a The Increasing Influence
of Institutional Owners
• Institutional owners are financial institutions, such as
mutual funds and pension funds, that control large-block
shareholder positions.
• Institutional owners:
• Are a powerful force in corporate America
• Estimates of the amount of equity in U.S. firms held by institutional
owners range from 60 to 75 percent.
• Can significantly influence a firm’s choice of strategies and
strategic decisions
• By using their positions of concentrated ownership, institutional
owners can force managers and boards of directors to make
decisions that best serve shareholders’ interests.
10-3 Board of Directors (slide 1 of 3)
• A board of directors is a group of elected individuals
whose primary responsibility is to act in the owners’ best
interests by formally monitoring and controlling the firm’s
top-level managers.
• Shareholders elect the members of a firm’s board of
directors.
• Generally, board members are classified into one of
three groups:
1. Insiders
2. Related outsiders
3. Outsiders
Table 10.1
Classification of Board of Directors’ Members
Insiders
• The firm’s CEO and other top-level managers
Related outsiders
• Individuals not involved with the firm’s day-to-day operations, but who have a
relationship with the company
Outsiders
• Individuals who are independent of the firm in terms of day-to-day operations
and other relationships
• Historically, inside managers dominated a firm’s

board of directors.
• There are benefits and drawbacks to having insider-
dominated boards.
• Because they work with and lead the firm daily, insiders have
access to information that facilitates forming and
implementing appropriate strategies.
• However, a widely accepted view is that a board with a
significant percentage of its membership from insiders provides
relatively weak monitoring and control of managerial decisions.
• Because of this, many critics advocate reforms to ensure that
independent outside directors are a significant majority of a
board’s total membership.
• Having a large number of outside board

members can also create some problems.
• Because outsiders typically do not have contact with
the firm’s day-to-day operations and do not have
ready access to detailed information:
• They lack the insights required to fully and effectively
evaluate managers’ decisions and initiatives.
• They may emphasize financial, as opposed to strategic,
controls to gather performance information to evaluate
managers’ and business units’ performance.
• A virtually exclusive reliance on financial evaluations shifts risk
to top-level managers who, in turn, may make decisions to
maximize their interests and reduce their employment risk.
10-3a Enhancing the Effectiveness
of the Board of Directors
• Because of increased scrutiny from shareholders and
the importance of boards of directors in corporate
governance, the performances of boards are being
evaluated more formally and with greater intensity.
• The demand for improved performance and greater accountability
is stimulating many boards to make changes, such as:
• Increasing the diversity of the backgrounds of board members
• Strengthening internal management and accounting control systems
• Establishing and consistently using formal processes to evaluate
board members’ performance
• Modifying the compensation of directors, especially reducing or
eliminating stock options as part of their package
• Creating a “lead director” role that has strong powers with regard to the
board agenda and oversight of non-management board activities
10-3b Executive Compensation
(slide 1 of 2)
• Executive compensation is a governance mechanism

that seeks to align the interests of managers and owners
through salaries, bonuses, and long-term incentives
such as stock awards and options.
• Executive compensation is a highly visible and often
criticized governance mechanism.
• Some believe that top-management team members, and
certainly C E Os, have a great deal of responsibility for a firm’s
performance and that they should be rewarded accordingly.
• Others conclude that these individuals are greatly overpaid and
that their compensation is not as strongly related to firm
performance as should be the case.
10-3b Executive Compensation
(slide 2 of 2)
• Effectively using executive compensation as a

governance mechanism is particularly challenging for
firms implementing international strategies.
• Developing an array of unique compensation plans requires
additional monitoring, potentially increasing the firm’s agency
costs.
• Pay levels vary by regions of the world.
• Acquiring firms and participating in joint ventures in other
countries increases the complexity associated with a board of
directors’ efforts to use executive compensation as an effective
internal corporate governance mechanism.
10-3c The Effectiveness of
Executive Compensation (slide 1 of 2)
• As an internal governance mechanism, executive compensation—
especially long-term incentive compensation—is complicated, for
several reasons.
• Because strategic decisions top-level managers make are complex and
non routine, direct supervision (even by the firm’s board of directors) is
likely to be ineffective as a means of judging the quality of their
decisions.
• It is difficult to assess the effects of top-level managers’ decisions on a
regular basis (e.g., annually) because they are stronger on the firm’s
long-term performance than its short-term performance.
• It is difficult to separate the effects of unpredictable changes in
segments (economic, demographic, political / legal, e t c.) on a firm’s
performance from the effects of top-level managerial decisions and
behavior.
10-3c The Effectiveness of
Executive Compensation (slide 2 of 2)
• Executive compensation as a governance mechanism
has a number of potential drawbacks.
• Incentive compensation is subject to managerial manipulation.
• Annual bonuses may provide incentives to pursue short-run
objectives at the expense of the firm’s long-term interests.
• Long-term, performance-based incentives increase executive
exposure to risks associated with uncontrollable events, such as
market fluctuations and industry decline.
• Long-term incentives tie a manager’s overall wealth to the firm in
an inflexible way, and such incentives may not be valued as highly
by a manager as by outside investors who have the opportunity to
diversify their wealth in a number of other financial investments.
• Thus, firms may have to overcompensate for managers using long-
term incentives.
10-4 Market for Corporate Control
(slide 1 of 2)
• The market for corporate control is an external governance

mechanism that is active when a firm’s internal governance
mechanisms fail.
• The market for corporate control is composed of individuals and
firms that buy ownership positions in or purchase all of potentially
undervalued corporations typically for the purpose of forming new
divisions in established companies or merging two previously
separate firms.
• An effective market for corporate control ensures that ineffective
and/or opportunistic top-level managers are disciplined.
• Because the top-level managers are assumed to be responsible for the
undervalued firm’s poor performance, they are usually replaced.
10-4 Market for Corporate Control
(slide 2 of 2)
• As a governance mechanism, investors

sometimes use the market for corporate control
to take an ownership position in firms that are
performing well.
• This suggests that the market for corporate control is
an imperfect governance mechanism.
10-4a Managerial Defense Tactics
(slide 1 of 2)
• In the majority of cases, hostile takeovers are the

principal means by which the market for corporate
control is activated.
• A hostile takeover is an acquisition of a target company by an
acquiring firm that is accomplished not by coming to an
agreement with the target company’s management but by going
directly to the company’s shareholders or fighting to replace
management in order to get the acquisition approved.
• Firms targeted for a hostile takeover may use multiple
defense tactics to fend off the takeover attempt.
• Increased use of the market for corporate control has enhanced
the sophistication and variety of managerial defense tactics that
are used in takeovers.
Table 10.2
Hostile Takeover Defense Strategies
10-4a Managerial Defense Tactics
(slide 2 of 2)
• In general, managers’ use of defense tactics is

considered self-serving in nature.
• Most institutional investors oppose the use of defense
tactics because such defenses are generally seen as
a way to entrench top managers in their positions.
10-5 International
Corporate Governance
• Corporate governance is an increasingly important issue in
economies around the world, including emerging economies.
• Globalization in trade, investments, and equity markets is
stimulating an increase in the intensity of efforts to:
• Improve corporate governance
• Potentially reduce the variation in regions’ and nations’ governance
systems
• However, the reality remains that different nations have different
governance systems in place.
• Recognizing and understanding differences in various countries’
governance systems, as well as changes taking place within those
systems, improves the likelihood a firm will be able to compete
successfully in the international markets it chooses to enter.
10-5a Corporate Governance
in Germany and Japan (slide 1 of 6)
• Concentration of ownership is an important means of corporate
governance in Germany.
• In many private German firms, the owner and manager may be the
same individual.
• In publicly traded German corporations, a single shareholder is often
dominant.
• Historically, banks occupied the center of the German corporate
governance system.
• The banks monitor and control managers, both as lenders and as
shareholders, by electing representatives to supervisory boards.
• The corporate governance practices in Germany make it difficult to
restructure companies as quickly as can be done in the United
States.
• There is a significant amount of cross-shareholdings among firms,
which makes takeovers more difficult.
• German firms with more than 2,000 employees are required to have
a two-tiered board structure that places the responsibility for
monitoring and controlling managerial (or supervisory) decisions
and actions in the hands of a separate group.
• The management board, which controls all the functions of strategy and
management, is known as the Vorstand.
• The supervisory tier is called the Aufsichtsrat.
• The appointment of members to each tier differs.
• Members of the Aufsichtsrat are appointed by the Vorstand.
• Employees, union members, and shareholders appoint members to the
Aufsichstrat.
• The German two-tiered system has both supporters and critics.
• Proponents suggest it helps prevent corporate wrongdoing and rash
decisions by “dictatorial C E Os.”
• Critics say that it slows decision making and often ties a C E O’s hands.
• Historically, German executives have not been dedicated to
maximizing shareholder wealth to the degree that is the case for
top-level managers in the United States and United Kingdom.
• Because of the role of local government (through the board structure)
and the power of banks in Germany’s corporate governance structure,
private shareholders rarely have major ownership positions in German
firms.
• Large institutional investors, such as pension funds (outside of banks
and insurance companies), are relatively insignificant owners of
corporate stock.
• However, corporate governance practices used in Germany have
been changing in recent years and are gravitating toward U.S.
governance mechanisms.
• Attitudes toward corporate governance in Japan are
affected by the concepts of:
• Obligation
• Family
• A company is considered a family; families command the attention
and allegiance of parties throughout corporations.
• A keiretsu (a group of firms tied together by cross-shareholdings) is
more than an economic concept—it, too, is a family.
• Consensus
• Consensus calls for the expenditure of significant amounts of
energy to win the hearts and minds of people whenever possible,
as opposed to top-level managers issuing edicts.
• Consensus is valued even when it results in a slow and
cumbersome decision-making process.
• Banks in Japan have an important role as a
corporate governance mechanism in large public
firms.
• The main bank in the keiretsu:
• Owns a large share position and holds a large amount of
corporate debt
• Has the closest relationship with a firm’s top-level managers
• Provides financial advice to the firm
• Closely monitors managers
• Japan’s corporate governance practices have been
changing in recent years.
• Japanese banks’ role in the monitoring and control of managerial
behavior and firm outcomes is less significant than in the past.
• Deregulation in the financial sector has:
• Reduced the cost of mounting hostile takeovers
• Facilitated additional activity in Japan’s market for corporate
control, which was nonexistent in past years
• Independent, non executive board members are increasingly
important in Japanese firms.
• Long-term executive compensation (e.g., stock options) is
increasingly important to foster improved performance.
10-5b Corporate Governance
in China (slide 1 of 2)
• The stock markets of China, which were once weak due
to significant insider trading, are still young and
developing.
• There has been a gradual decline in China in the equity
held in state-owned enterprises, while the number and
percentage of private firms has grown.
• However, the state still relies on direct and / or indirect controls
to influence the strategies firms use.
• Private firms try to develop political ties with the government
because of their role in providing access to resources and to the
economy.
10-5b Corporate Governance
in China (slide 2 of 2)
• In light of the increasing privatization of
businesses and the development of equity
markets, the government has done much to
improve the corporate governance of listed
companies.
• Some evidence suggests that corporate governance
in China may be tilting toward the Western model.
10-6 Governance Mechanisms
and Ethical Behavior (slide 1 of 2)
• 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 stakeholders (e.g., customers and suppliers)
• Organizational stakeholders (e.g., managerial and non-managerial
employees)
• Otherwise, a firm risks seeing its dissatisfied
stakeholders withdraw their support from the firm and
provide it to another.
• Example: Customers will purchase products from a supplier
offering an acceptable substitute.
10-6 Governance Mechanisms
and Ethical Behavior (slide 2 of 2)
• Some believe that the internal corporate governance
mechanisms designed and used by ethically responsible
leaders and companies increase the likelihood the firm
will be able to, at least, minimally satisfy all stakeholders’
interests.
• The most effective boards of directors set boundaries for their
firms’ business ethics and values.
• As agents of the firm’s owners, the board—acting as an internal
governance mechanism—holds top-level managers fully
accountable for developing and supporting an organizational culture
in which only ethical behaviors are permitted.
APPENDIX
NOTE TO INSTRUCTOR: Choose from the following questions (also found in the text at the end of the chapter)
to conduct in-class discussions around key chapter concepts.
Discussion:
• What is corporate governance? What factors

account for the considerable amount of attention
corporate governance receives from several
parties, including shareholder activists, business
press writers, and academic scholars? Why is
governance necessary to control managers’
decisions?
Discussion:
• What is meant by the statement that ownership

is separated from managerial control in the
corporation? Why does this separation exist?
Discussion:
• What is an agency relationship? What is

managerial opportunism? What assumptions do
owners of corporations make about managers
as agents
Discussion:
• How is each of the three internal governance

mechanisms—ownership concentration, boards
of directors, and executive compensation—used
to align the interests of managerial agents with
those of the firm’s owners?
Discussion:
• What trends exist regarding executive

compensation? What is the effect of the
increased use of long-term incentives on top-
level managers’ strategic decisions?
Discussion:
• What is the market for corporate control? What

conditions generally cause this external
governance mechanism to become active? How
does this mechanism constrain top-level
managers’ decisions and actions?
Discussion:
• What is the nature of corporate governance in

Germany, Japan, and China?
Discussion:
• How can corporate governance foster ethical

decisions and behaviors on the part of
managers as agents?

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CHAPTER

• Ownership concentration is defined by the

• Ownership concentration influences decisions

• Historically, inside managers dominated a firm’s

• Having a large number of outside board

• Executive compensation is a governance mechanism

• Effectively using executive compensation as a

• The market for corporate control is an external governance

• As a governance mechanism, investors

• In the majority of cases, hostile takeovers are the

• In general, managers’ use of defense tactics is

• What is corporate governance? What factors

• What is meant by the statement that ownership

• What is an agency relationship? What is

• How is each of the three internal governance

• What trends exist regarding executive

• What is the market for corporate control? What

• What is the nature of corporate governance in

• How can corporate governance foster ethical

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