STAKEHOLDERS, THE MISSION, GOVERNANCE, AND BUSINESS ETHICS CHAPTER OUTLINE Stakeholders Corporate Governance and Strategy ‘esi The Agency Problem The Mission Statement eae ea The Mission . Vision Ethics and Strategy Values Ethical Issues in Strategy ‘Mejor Goals The Roots of Unethical Behavior Behaving Ethically Final Words LEARNING OBJECTIVES After reading this chapter you shouldbe» Review the causes of poor business able to: ethics. ‘+ Explain why managers need to take + Discuss how managers can ensure that stakeholder claims into account. the stratogic decisions they make are + Discuss the components of a corporate consistent with good ethical principles. mission statement. Explain the role played by corporate governance mechanisms in the management of a company.28 Stakeholders Individuals or groups with an interest, claim, or stake in the ‘company, in what it does, and in how well it performs. Corporate Governance The mechanisms that exist to ensure that managers pursue strategies in the interests of an important stakeholder group, the shareholders. Internal Stakeholders Stockholders and employees, including executive officers, other managers, and board members. External Stakeholders Individuals and groups outside the company that have some claim on the company, Part 1 Introduction to Strategic Management OVERVIEW An important part of the strategy making process is ensuring that the company maintains the support of the key constituencies—or stakeholders—upon which it depends for its functioning and ultimate survival. A company’s stakeholders are in- dividuals or groups with an interest, claim, or stake in the company, in what it does, and in how well it performs.’ We begin by looking at the relationship between stakeholders and a company. Then we move on to consider the corporate mission statement, which is the first key indicator of how an organization views the claims of its stakeholders. The purpose of the mission statement is to establish the guiding principles for strategic decision making. As we shall see, these guiding principles should recognize the claims of important stakeholder groups. Next we explore the issue of corporate governance. By corporate governance, we mean the mechanisms that exist to ensure that man- agers pursue strategies that are in the interests of an important stakeholder group— shareholders. The chapter closes with a discussion of the ethical implications of strategic decisions. We consider how managers can make sure that their strategic deci sions are founded on strong principles that treat all stakeholders in an ethical manner. STAKEHOLDERS A company’s stakeholders can be divided into internal stakeholders and external stakeholders (see Figure 2.1). Internal stakeholders are stockholders and employ- ces, including executive officers, other managers, and board members. External stakeholders are all other individuals and groups that have some claim on the com- pany. Typically, this group comprises customers, suppliers, creditors (including banks and bondholders), governments, unions, local communities, and the general public. All stakeholders are in an exchange relationship with the company. Each stake- holder group supplies the organization with important resources (or contribu- tions), and in exchange each expects its interests to be satisfied (by inducements) 2 Stockholders provide the enterprise with risk capital and in exchange expect manage- ‘ment to try to maximize the return on their investment. Creditors such as bondholders provide the company with capital in the form of debt, and they expect to be repaid on time with interest. Employees provide labor and skills and in exchange expect Figure 2.1 Stakeholders and the Enterprise External Internal Stakeholders Contributions Inducements Stakeholders + Customers + Stockholders + Suppliers: + Employees + Creditors, + Managers + Governments, + Senior Executives + Unions + Board Members + Local Communities ingucements + General Public ContributionsChapter 2 Stakeholders, The Mission, Governance, and Business Ethics commensurate income, job satisfaction, job security, and good working conditions. ‘Customers provide a company with its revenues and in exchange want high-quality reliable products that represent value for money. Suppliers provide a company with inputs and in exchange seek revenues and dependable buyers. Governments provide a company with rules and regulations that govern business practice and maintain fair competition. In exchange they want companies that adhere to these rules and pay their taxes, Unions help to provide a company with productive employees and in, exchange they want benefits for their members in proportion to their contributions to the company. Local communities provide companies with local infrastructure and in exchange want companies that are responsible citizens. The general public pro vides companies with national infrastructure and in exchange seeks some assurance that the quality of life will be improved as a result of the company’s existence. ‘A company should take these claims into account when formulating its strate- gies. If it does not stakeholders may withdraw their support. Stockholders may sell their shares, bondholders demand higher interest payments on new bonds, employ- ces leave their jobs, and customers buy elsewhere. Suppliers may seek more depend- able buyers. Unions may engage in disruptive labor disputes. Government may take civil or criminal action against the company and its top officers, imposing fines and in some cases jail terms. Communities may oppose the company’s attempts to locate its facilites in their area, and the general public may form pressure groups, demand- ing action against companies that impair the quality of life. Any of these reactions can have a damaging impact on an enterprise. ‘Managers cannot always satisfy the claims of all stakeholders. The goals of dif- ferent groups may conflict, and in practice few organizations have the resources to satisfy all stakeholder claims.’ For example, union claims for higher wages can conflict with consumer demands for reasonable prices and stockholder demands for acceptable returns. Often, the company must make choices. To do so, it must iden- tify the most important stakeholders and give highest priority to pursuing strategies that satisfy their needs. Stakeholder impact analysis can provide such identification. Typically, stakeholder impact analysis follows these steps: Identify stakeholders Identify stakeholders’ interests and concerns ‘Asa result, identify what claims stakeholders are likely to make on the organization Identify the stakeholders who are most important from the organization’s perspective 5. Identify the resulting strategic challenges‘ pepe Such an analysis enables a company to identify the stakeholders most critical to its survival and to make sure that the satisfaction of their needs is paramount. Most, companies that have gone through this process quickly come to the conclusion that, three stakeholder groups must be satisfied above all others if a company is to survive and prosper: customers, employees, and stockholders.* THE MISSION STATEMENT As noted above, a company’s mission statement is a key indicator of how an orga nization views the claims of its stakeholders. You will also recall that in Chapter 1 we stated that the mission statement represented the starting point of the strategic 29Mission What itis that the company exists to do. Part 1 Introduction to Strategic Management planning process. Although corporate mission statements vary, the most com- prehensive include four main elements; the mission, vision, values, and goals of a corporation. The Mission ‘The mission describes what it is that the company does. For example, the mission of Kodak is to provide “customers with the solutions they need to capture, store, process, output, and communicate images—anywhere, anytime.”* Kodak is a com- pany that exists to provide imaging solutions to consumers. This missions focuses con the customer need that the company is trying to satisfy (the need for imaging), as opposed to the products that the company produces (film and cameras). This is a customer-oriented rather than product-oriented mission, An important first step in the process of formulating a mission is to come up with, a definition of the organization's business, Essentially, the definition should answer these questions: “What is our business? What will it be? What should it be?” The re- sponses guide the formulation of the mission. To answer the question, “What is our business?” a company should define its business in terms of three dimensions: who is being satisfied (what customer groups), what is being satisfied (what customer needs), and how customers’ needs are being satisfied (by what skills, knowledge, or competencies).* Figure 2.2 illustrates these dimensions. This approach stresses the need for a customer-oriented rather than a product- oriented business definition. A product-oriented business definition focuses on the Figure 2.2 Defining the Business Whatis being satisfied? Customer needs Source: D. F Abel, Defining tho Businoss: The Starting Point of Strategic Planing (Englewood Cis, Prentice-Hall, 1980), 7Chapter 2 Stakeholders, The Mission, Governance, and Business Ethics characteristics of the products sold and markets served, not on which kinds of cus- tomer needs the products are satisfying. Such an approach obscures the company’s true mission because a product is only the physical manifestation of applying a par- ticular skill to satisfy a particular need for a particular customer group. In practice, that need may be served in many different ways, and a broad customer-oriented business definition that identifies these ways can safeguard companies from being caught unaware by major shifts in demand. By helping anticipate demand shifts, a customer-oriented mission statement can also assist companies to capitalize on changes in their environment. It can help an- swer the question, “What will our business be?” Recall that Kodak’s mission em phasizes the company’s desire to provide customers with the solutions they need to capture, store, process, output, and communicate images. This is a customer-oriented mission statement that focuses on customer needs, as opposed to a particular prod- uct (or solution) for satisfying those needs, This customer-oriented business defini tion has helped drive Kodak’s investments in digital imaging technologies, since the early 1990s, which have replaced much of Kodak’s traditional business based on chemical film processing, The need to take a customer-oriented view of a company’s business has often been ignored. History is littered with the wreckage of once-great corporations that did not define their business or defined it incorrectly so that ultimately they declined. In the 1950s and 1960s, there were many office equipment companies such as Smith Corona and Underwood that defined their businesses as being the production of typewriters, This product-oriented definition ignored the fact that they were really in the business of satisfying customers’ information processing needs. Unfortunately for those companies, when a new technology came along that better served customer weeds for information processing (computers), demand for typewriters plummeted. Phe last great typewriter company, Smith Corona, went bankrupt in 1996, a victim of the success of computer-based word processing technology. In contrast, IBM correctly foresaw what its business would be. In the 1950s, IBM was a leader in the manufacture of typewriters and mechanical tabulating equipment using punch card technology. However, unlike many of its competitors, IBM defined its business as providing a means for information processing and storage, rather than just supplying mechanical tabulating equipment and typewriters.’ Given this, definition, the company’s subsequent moves into computers, software systems, office systems, and printers seem logical. Vision The vision of a company lays out some desired future state—it articulates, often in bold terms, what the company would like to achieve. For example, Nokia, the world’s largest manufacturer of mobile (wireless) phones, has been operating with a very simple but powerful vision for some time: “If it can go mobile, it will!” This vision implied that not only would voice telephony go mobile, but also a host of other services based on data, such as imaging and Internet browsing. This vision led Nokia to become one of the early leaders in developing “smart” mobile handsets that not only can be used for voice communication but that also take pictures, browse the Internet, play games, and manipulate personal and corporate information. Good vision statements are meant to stretch a company by articulating some ambitious, but attainable future state that will help to motivate employees at all levels and drive strategies." Vision The desired future state of a company, 3132 Values Statements of how managers, and employees of ‘a company should conduct themselves, how they should do business, and what kind of organization they should build to help a company achieve its mission. Organizational Culture The set of values, norms, and standards that control how employees work to achieve an organization's mission and goals. Goal Aprecise and measurable desired future state that 2 company attempts, to realize, Part 1 Introduction to Strategic Management Values ‘The values of a company state how managers and employees should conduct them- selves, how they should do business, and what kind of organization they should build to help a company achieve its mission. Insofar as they help drive and shape behavior within a company, values are commonly seen as the bedrock of a company’s organi- zational culture: the set of values, norms, and standards that control how employees work to achieve an organization’s mission and goals. An organization’s culture is of- ten seen as an important source of its competitive advantage." (We discuss the issue of organization culture in depth in Chapter 9.) For example, Nucor Steel is one of the most productive and profitable steel firms in the world. Its competitive advantage is based in part on the extremely high productivity of its workforce, something, the company maintains, that is a direct result of its cultural values, which shape how it treats its employees. These values are as follow: + “Management is obligated to manage Nucor in such a way that employees will have the opportunity to earn according to their productivity.” + “Employees should be able to feel confident that if they do their jobs properly, they will have a job tomorrow: + “Employees have the right to be treated fairly and must believe that they will be.” + “Employees must have an avenue of appeal when they believe they are being treated unfairly.” At Nucos, values emphasizing pay for performance, job security, and fair treat- ment for employees help to create an atmosphere within the company that leads to high employee productivity. In turn, this has helped to give Nucor one of the lowest cost structures in its industry, which helps to explain the company’s profitability in a very price-competitive business. Major Goals Having stated the mission, vision, and key values, strategic managers can take the next step in the formulation of a mission statement: establishing major goals. A goal is a precise and measurable desired future state that a company attempts to realize. In this context, the purpose of goals is to specify with precision what must be done if the company is to attain its mission or vision. ‘Well-constructed goals have four main characteristics: 1. They are precise and measurable. Measurable goals give managers a yardstick or standard against which they can judge their performance. 2. They address crucial issues. To maintain focus, managers should select a limited number of major goals to assess the performance of the company. The goals that are selected should be crucial or important ones. 3. They are challenging but realistic. They give all employees an incentive to look for ways of improving the operations of an organization. If a goal is unrealistic in the challenges it poses, employees may give ups a goal that is too easy may fail to motivate managers and other employees."* 4. They specify a time period in which they should be achieved when that is appropriate. Time constraints tell employees that success requires a goal to be attained by a given date, not after that date. Deadlines can inject a sense of urgency into goal attainment and act as a motivator. However, not all goals require time constraints.Chapter 2 Stakeholders, The Mission, Governance, and Business Ethics Well-constructed goals also provide a means by which the performance of man- agers can be evaluated. Although most companies operate with a variety of goals, the central goal of most corporations is to maximize sharcholder returns, and maximizing sharcholder returns requires high profitability and profit growth." Thus, most companies oper- ate with goals for profitability and profit growth. However, it is important that top managers do not make the mistake of overemphasizing current profitability to the detriment of long-term profitability and profit geowth."* The overzealous pursuit ‘of current profitability to maximize short-term performance can encourage such misguided managerial actions as cutting expenditures judged to be nonessential in the short run—for instance, expenditures for research and development, marketing, and new capital investments. Although cutting current expenditure increases current profitability, the resulting underinvestment, lack of innovation, and diminished mar- keting can jeopardize long-run profitability and profit growth. These expenditures are vital if a company is to pursue its long-term mission and sustain its competitive advantage and profitability over time. Despite these negative consequences, manag- ers may make such decisions because the adverse effects of a short-run orientation ‘may not materialize and become apparent to shareholders for several years or be cause they are under extreme pressure to hit short-term profitability goals."” It is also worth noting that pressures to maximize short-term profitability may result in managers’ acting in an unethical manner. This apparently occurred dur- ing the late 1990s at a number of companies including Enron Corporation, Tyco, WorldCom, and Computer Associates. In these companies, profits were systemati- cally inflated by managers who manipulated financial accounts in a manner that misrepresented the true performance of the firm to shareholders. To guard against short-run behavior, managers need to ensure that they adopt goals whose attainment will increase the long-run performance and competitiveness of their enterprise. Long-term goals are related to such issues as product develop- ment, customer satisfaction, and efficiency, and they emphasize specific objectives or targets concerning such things as employee and capital productivity, product quality, and innovation. CORPORATE GOVERNANCE AND STRATEGY ‘We noted that a central goal of most companies is to provide its stockholders a good rate of return on their investment. There are good reasons for this. Stockholders are the legal owners of a company and the providers of risk capital. The capital that stockholders provide to a company is seen as risk capital because there is no guar- antee that stockholders will ever recoup their investment of earn a decent return (publicly held corporations can and go bankrupt, in which case stockholders will lose their capital investment). In publicly held corporations, stockholders delegate the job of controlling the com pany and selecting its strategies to professional managers, who become the agents of the stockholders." As the agents of stockholders, managers should pursue strategies that maximize long-run returns to stockholders (subject to the constraint that they do so in a manner that is both legal and ethical). Although most managers are diligent about do- ing so, not all actin this fashion. This failure gives rise to what is known as the agency problem, where managers pursue strategies that are not in the interests of stockholders. 33 Ethical Dilemma You work for a US-based textile company struggling with overseas competitors that have access to low- ‘cost labor. While you pay your factory workers $14 {an hour plus benefits, you know that a similar tex: tile mil in Vietnam is pay- ing its employees about $0.50 an hour, and the mill does not have to comply with te same safety and environmental. regulations that your company does Although your mill is, marginally profitable, the Vietnamese factory cleeriy has a cost advantage. Your CEO wants to move pro- duction to Vietnam where labor and compliance costs are lower, resulting in mill closure and employes lay- offs, Your mill is the only large employer in a smal community. Many of the employees have worked there their entre working lives. What is the right ac- tion to take for stockhold- fers? What is the most cthical course of action? Is, there a confct here? Risk Capital Equity capital for which ere is no guarantee at stockholders will ever recoup their investment or earn a decent return, Agency Problem A problem that arises when managers pursue strategies that are not in the interests stockholders.34 Agency Theory A theory dealing with the problems that can arise ina business relationship when one person delegates decision-making authority to another. Agency Relationship Arelationship that arises whenever one party delegates decision-making authority or control over resources to another. Principal A person delegating authority to an agent, who acts on the principal's behalf Agent ‘A person to whom authority is delegated by a principal Information Asymmetry A situation in which one party to an exchange has more information about the exchange than the other party. Part 1 Introduction to Strategic Management The Agency Problem A branch of economics known as agency theory looks at the agency problems that can arise in a business relationship when one person delegates decision-making authority to another. Agency theory offers a way of understanding why managers do not always act in the best interests of stakeholders, and also why they might sometimes engage in actions that are unethical, and perhaps also illegal."” Although agency theory was originally formulated to capture the relationship between man- agement and stockholders, the basic principles have also been extended to cover the relationship with other key stakeholders, such as employees, as well as between different layers of management within a corporation2? While the focus of attention in this section is on the relationship between senior management and stockholders, it should not be forgotten that some of the same language can be applied to the relationship between other stakeholders and top managers and between top man- agement and lower levels of management. ‘The basic propositions of agency theory are relatively straightforward. First, an agency relationship is held to arise whenever one party delegates decision-making, authority or control over resources to another. The principal is the person delegating authority, and the agent is the person to whom authority is delegated. The relation- ship between stockholders and senior managers is the classic example of an agency relationship. Stockholders, who are the principals, provide the company with risk capital, but they delegate control over that capital to senior managers, and particu- larly the CEO, who as their agent is expected to use that capital in a manner that is, consistent with the best interests of stockholders. This means using that capital to maximize the company’s long-run profitability and profit growth rate. While agency relationships often work well, problems arise if agents and princi- pals have different goals, and if agents take actions that are not in the best interests of their principals. Agents may be able to do this because there is an information asymmetry between the principal and the agent; agents almost always have more information about the resources they are managing than the principal does. Unscrupulous agents can take advantage of any information asymmetry to mislead principals and maximize their own interests at the expense of principals. In the case of stockholders, the information asymmetry arises because they del- egate decision-making authority to the CEO, their agent, who by virtue of his or her position inside the company is likely to know far more than stockholders do about the company’s operations. The information asymmetry between principals and agents is not necessarily a bad thing, but it can make it difficult for principals to ‘measure how well an agent is performing, and thus hold the agent accountable for how well he or she is using the entrusted resources. There is a certain amount of per- formance ambiguity inherent in the relationship between a principal and agent: the principal cannot know for sure if the agent is acting in his or her best interests The principal cannot know for sure if the agent is using the resources to which he or she has been entrusted as effectively and efficiently as possible. To an extent, princi- pal has to trust the agent to do the right thing. This trust is not blind: principals do put governance mechanisms in place whose purpose is to monitor agents, evaluate their performance, and if necessary, take cor rective action, As we shall sce shortly, the board of directors is one such governance mechanism, for in part the board exists to monitor and evaluate senior manag- ers on behalf of stockholders. Other mechanisms serve a similar purpose. In the United States, the requirement that publicly owned companies regularly file detailedChapter 2 Stakeholders, The Mission, Governance, and Business Ethics financial statements with the Securities and Exchange Commission (SEC) that are in accordance with generally agreed accounting principles (GAAP) exists to give stock: holders consistent and detailed information about how well management is using the capital to which they have been entrusted, Despite the existence of governance mechanisms and comprehensive measure- ment and control systems, a degrce of information asymmetry will always remain between principals and agents, and there is always an element of trust involved in the relationship. Unfortunately, not all agents are worthy of this trust. A minority will deliberately mislead principals for personal gain, sometimes behaving unethically or breaking laws in the process. The interests of principals and agents are not always the same; they diverge, and some agents may take advantage of information asym- metries to maximize their own interests at the expense of principals, and to engage in behaviors that the principals would never condone For example, some authors have argued that like many other people, senior man- agers are motivated by desires for status, power, job security, and income.” By vir- tue of their position within the company, certain managers, such as the CEO, can use their authority and control over corporate funds to satisfy these desires at the cost of returns to stockholders. CEOs might use their position to invest corporate funds in various perks that enhance their status—executive jets, lavish offices, and expense-paid trips to exotic locations—rather than investing those funds in. ways that increase stockholder returns. Economists have termed such behavior on-the-job 2.1 STRATEGY IN ACTION The Agency Problem at Tyco Under the leadership of Dennis Kozlowski, who became CEO of Tyco in 1990, the company’s revenues expanded from $3.1 billion in 1992 to $38 billion in 2001. Most of this growth was due to 4 series of acquisitions that took ‘co into a diverse range of unrelated businesses. Tyco finance the acquisitions by taking on significant deb commitments, which by 2002 exceeded $23 billion. As ‘Tyco expanded, some questioned Tyco's ability to service its debt commitments, and claimed that was engaging in “accounting tricks” to pad its books and make the company appear more profitable than it actu- ally was. These criticisms, which were ignored for several years, were finally shown to have some validity in 2002 when Kozlowski was forced out by the board and subse- quently charged with tax evasion by federal authorities. ‘Among other charges, federal authorities claimed that Kozlowski treated Tyco as his personal treasury, drawing ‘on company funds to purchase an expensive Manhattan apartment and @ world class art collection that he obvi: ously thought were befitting of the CEO of a major com poration. Kozlowski even used company funds to help pay for an expensive birthday party for his wife—which included toga-clad ladies, gladiators, a naked-woman- with-exploding-breasts birthday cake and a version of Michelangelo's David that peed vodka! Kozlowski was replaced by @ company outsider, Edward Breen. In 2003 Tyco took a $15 billion charge against earings for accounting errors made during the Kozlowski era ie., Tyco's profits had been overstated by $1.5 billion during Kozlowski’s tenure). Breen also set about ais- mantling parts of the empire that Kozlowski had but, divesting several businesses ‘After a lengthy criminal trial, in June 2005 Dennis Kozlowski and Mark Swartz, the former chief financial officer of Tyco, were convicted of 23 counts of grand lar ceny, conspiracy, securities fraud, and falsifying business records in connection with what prosecutors described as the systematic looting of millions of dollars from the conglomerate (Kozlowski was found guilty of looting $90 million from Tyco!. Both were set to serve significant jail time, As for Tyco, in 2008 CEO Ed Breen announced that the company would be broken up into three parts, a t to the strategic incoherence of the conglom- erate that Kozlowski built. 35