Corporate Performance, Governance, and Business Ethics IFT Notes

1. Introduction ............................................................................................................................. 2
2. Stakeholders and Corporate Performance ............................................................................... 2
2.1. Stakeholder Impact Analysis ............................................................................................... 3
2.2. The Unique Role of Stockholders ........................................................................................ 3
2.3. Profitability, Profit Growth, and Stakeholder Claims .......................................................... 4
3. Agency Theory ........................................................................................................................ 4
3.1. Principal–Agent Relationships............................................................................................. 4
3.2. The Agency Problem ........................................................................................................... 5
4. Ethics and Strategy .................................................................................................................. 6
4.1. Ethical Issues in Strategy ..................................................................................................... 6
4.2. The Roots of Unethical Behavior ........................................................................................ 7
4.3. Philosophical Approaches to Ethics..................................................................................... 7
4.4. Behaving Ethically ............................................................................................................... 9
5. Summary................................................................................................................................ 10

This document should be read in conjunction with the corresponding reading in the 2018 Level II
CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are
copyright 2017, CFA Institute. Reproduced and republished with permission from CFA Institute.
All rights reserved.

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or
quality of the products or services offered by IFT. CFA Institute, CFA®, and Chartered
Financial Analyst® are trademarks owned by CFA Institute.

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 Corporate Performance, Governance, and Business Ethics IFT Notes

1. Introduction
In this reading, we look at the corporate governance mechanisms that shareholders put in place to
ensure that managers are acting in their interest. We also discuss how balancing the interests of
different stakeholders such as shareholders, customers, employees and suppliers is beneficial for
the company in the long run. In addition, we will review some of the philosophical approaches to
ethics.

LO.a: Compare interests of key stakeholder groups and explain the purpose of a
stakeholder impact analysis.

2. Stakeholders and Corporate Performance

A company’s stakeholder is an individual or group that has an interest, claim or stake in the
company. Stakeholders can be classified as internal stakeholders and external stakeholders as
shown in Figure 1 from the curriculum.

Internal stakeholders include stockholders and employees (including managers and board
members). External stakeholders typically include customers, suppliers, creditors, governments,
unions, local communities and the general public.

All stakeholders are in an exchange relationship with the company. For example:
 Stockholders provide risk capital and in exchange expect a return on their investment.
 Creditors provide capital in the form of debt and in exchange expect to be repaid on time
with interest.
 Employees provide labor and skills and in exchange expect compensation, job security,
job satisfaction and good working conditions.
 Customers provide revenues and in exchange want products and services that are value
for money.
 Suppliers provide input materials and in exchange want payment.
 Governments provide rules and regulations and in exchange want companies to follow
rules and pay taxes.

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 Corporate Performance, Governance, and Business Ethics IFT Notes

 Unions provide companies with productive employees and in exchange want benefits for
their members.
 Local communities provide local infrastructure and in exchange want companies to be
responsible citizens.

A company must consider all these exchange relationships when formulating strategies or else
the stakeholders might withdraw their support. For example:
 Stockholders may sell their stocks
 Bondholders may demand higher interest.
 Employees may leave jobs.
 Customers may buy from someone else.
 Suppliers may stop dealing with the company.
 Unions may engage in disruptive labor disputes.
 Governments may take civil or criminal action against the company.
 Communities may oppose the company’s attempt to locate its facilities in their area.
 General public may form pressure groups and demand action against companies that
damage the quality of life.

2.1. Stakeholder Impact Analysis

Stakeholders may have conflicting demands. For example, union claims for high wages can
conflict with customer demand for low prices and stockholder demands for high returns.
Companies, therefore, cannot satisfy the claims of all stakeholders.

Hence, companies need to identify the most important stakeholders and give highest priority to
follow strategies that fulfill their needs. Stakeholder impact analysis is used for such
identification. The typical steps in a stakeholder impact analysis are:
1. Identify stakeholders.
2. Identify stakeholders’ interests and concerns.
3. As a result, identify what claims stakeholders are likely to make on the organization.
4. Identify the stakeholders who are most important from the organization’s perspective.
5. Identify the resulting strategic challenges.

Companies that carry out this analysis usually find that the most important stakeholders are:
customers, employees and stockholders.

2.2. The Unique Role of Stockholders

Stockholders are legal owners of the company. They provide risk capital to the company which
allows a company to operate its business. To reward stockholders for providing capital,
management has to pursue strategies that maximize the returns stockholders receive from their
investment.

An employee stock ownership plan (ESOP) gives employees the opportunity to purchase stock in
their company. Over the past decade, more and more employees have become stockholders

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 Corporate Performance, Governance, and Business Ethics IFT Notes

through ESOPs. ESOPs have increased the emphasis on increasing stockholder returns because
now it helps satisfy two key stakeholder groups: stockholders and employees.

2.3. Profitability, Profit Growth, and Stakeholder Claims

Stockholders receive their returns in two ways: dividends and capital appreciation. The best way
for managers to generate funds for dividend payments and to keep the stock price appreciating is
to increase the company’s long-run profitability. Return on Invested Capital (ROIC) is an
excellent measure of profitability. It tells managers how efficiently they are using capital to
generate profits.

The relationship between profit growth and current profitability is complex. Future profit growth
may require investments that decrease the current profitability. Managers need to find the right
balance between profitability and profit growth.

In addition to satisfying stockholders, increasing a company’s profitability and profit growth

satisfies several other key stakeholders.
 A profitable company can pay better salaries and provide more benefits to its employees.
 A profitable company has no problems meeting the debt commitments of its creditors.
 A profitable company can afford philanthropic investments which benefit local
communities and general public.
 Suppliers like dealing with profitable companies because they can be assured that the
company will have the funds to pay them.
 Customers like buying from profitable companies because they can be assured that such
companies will be around in the long run to provide after sales services and support.

While pursuing profit growths the company must stay within the limit set by the law. At times
managers can be tempted to pursue illegal strategies to maximize profitability.

LO.b: Discuss problems that can arise in principal–agent relationships and mechanisms
that may mitigate such problems.

3. Agency Theory
Agency theory looks at problems that can arise when authority is delegated. While the focus of
this section is on the manager-shareholder relationship how, the theory can be applied more
broadly to other stakeholders as well.

3.1. Principal–Agent Relationships

When one party delegates authority to another, an agency relationship is created. The party
delegating the authority is called the principal. The party to whom the authority is delegated is
called the agent. We can have multilevel agency relationships within a company. For example,
shareholders delegate authority to senior managers like the CEO of the company. Senior
managers in turn can delegate authority to business unit managers. Business unit managers can

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 Corporate Performance, Governance, and Business Ethics IFT Notes

delegate authority to their team leaders. Thus whenever managers delegate authority to managers
below them in the hierarchy a principal-agent relationship is created.

3.2. The Agency Problem

Agency problems arise when the goals of agents are different from the goals of principals and
there is information asymmetry. Agents usually have more information about their projects than
principals. Some agents can take advantage of this and take actions that are not in the best
interest of their principals. To prevent this, principals may put the following mechanisms in place
to monitor agents:
 Board of Directors
 External Audits
 Internal Audits

However, despite these monitoring mechanisms some agents will still exploit the information
asymmetries.

One more concern for stockholders is that a CEO may engage in empire building to increase his
status, security, power and income. This may not be necessarily good for the company’s long-run
profitability. As show in Figure 2 from the curriculum there is a tradeoff between profitability
and revenue growth rate. A moderate revenue growth rate of G* will allow the company to
maximize long-run profitability, generating a return of Π*. However an empire building CEO
will target a growth rate of G2 which will give a lower profitability of Π2.

Agency problems can be serious and this was highlighted in early 2000, when a series of
corporate world scandals were discovered. These scandals were caused due to self-interest-
seeking senior executives and because corporate governance mechanisms failed to hold the
excess of those executives in check. Examples of such companies include, Enron, WorldCom,
Tyco, Computer Associates, HealthSouth, Adelphia Communications, Dynegy, Royal Dutch
Shell, and the major Italian food company, Parmalat.

To deal with agency problems, principals should:

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 Corporate Performance, Governance, and Business Ethics IFT Notes

1. Shape the behavior of agents so that they act in accordance with the goals set by
principals.
2. Reduce the information asymmetry between agents and principals.
3. Develop mechanisms for removing agents who do not act in accordance with the goals of
principals and mislead them.

LO.c: Discuss roots of unethical behavior and how managers might ensure that ethical
issues are considered in business decision making.

4. Ethics and Strategy

The term ethics refers to accepted principles of right or wrong that govern the conduct of a
person, the members of a profession, or the actions of an organization. Many accepted principles
of right and wrong have also been codified into law. In business, we have the following laws:
 Tort laws - Laws governing product liability
 Contract laws - Laws for contracts and breaches of contract
 Intellectual property law - Laws for the protection of intellectual property
 Antitrust law - Laws governing competitive behavior
 Securities law - Laws for selling of securities

Breaking these laws is not only unethical, but also illegal. However, it is possible that some
actions are unethical but not illegal. For example, Nike’s use of sweatshop labor in developing
nations was legal. Neither Nike nor its subcontractors were breaking any laws. However, when
compared to western standards, the long hours and poor pay in poor working conditions were
considered unethical by many people. Realizing this, Nike’s management took a number of
steps, like establishing a code of conduct and setting up annual audits for its subcontractors. The
code of conduct required that all employees be at least eighteen years old, the exposure to toxic
material would not exceed the permissible limits established for workers in US. Thus, sometimes
behaving ethically can go beyond staying within the boundaries of the law.

4.1. Ethical Issues in Strategy

Most ethical issues are caused due to a potential conflict between the goals of the company and
its mangers and the fundamental rights of the company’s main stakeholders. It is important to
note that stakeholders have basic rights that should be respected and it is unethical to violate
these rights. For example:
 Stockholders have the right to timely and accurate information via accounting statements.
 Customers have the right to be fully informed about the products and services they
purchase.
 Employees have the right to safe working conditions, fair compensation and just
treatment.
 Suppliers have the right to expect contracts to be respected.
 Competitors have the right to expect that the firm will abide by the rules of competition
and not violate the basic principles of antitrust laws.

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 Corporate Performance, Governance, and Business Ethics IFT Notes

 Community and general public have the right to expect that a company will respect their
basic expectations, and not engage in activates like dumping toxic pollutants,
overcharging for work performed on government contracts.

Proponents of the stakeholder view of business ethics often claim that respecting the
fundamental rights of stakeholders and behaving ethically is in the self-interest of managers.
Because, doing so will ensure the support of the stakeholders and thus ultimately benefit the
company. Others argue that acting ethically is simply the right thing to do in many cases. They
claim that companies need to recognize their noblesse oblige and give something back to the
society. (Noblesse oblige is a French term that refers to honorable and benevolent behavior that
is considered the responsibility of people of noble birth.)

Unethical behavior often arises from agency problems, when managers put their personal goals
above the fundamental rights of other stakeholders. Examples of such behavior include:
 Self-dealing – Mangers using corporate money to enrich themselves
 Information manipulation – Managers use their control over corporate data to distort or
hide information for personal gains.
 Anticompetitive behavior – Range of actions aimed at harming actual or potential
competitors, most often by using monopoly power.
 Opportunistic exploitation of other players in the value chain like suppliers and
distributers
 Creating substandard working conditions
 Environmental degradation
 Corruption

4.2. The Roots of Unethical Behavior

The following generalizations can be made about the roots of unethical behavior:
1. Business ethics go hand in hand with personal ethics. An individual with a strong sense
of personal ethics is less likely to behave in an unethical manner in a business setting.
2. At times businesspeople act unethically simply because they fail to ask the relevant
question: Is this decision or action ethical? They do not consider the ethical aspect of
their decisions.
3. Sometimes organizations de-emphasize business ethics and consider only economic
factors
4. There is often pressure from top management to meet performance goals
5. Unethical leadership: If leaders do not behave in an ethical manner, employees might not
either.

LO.d: Compare the Friedman doctrine, Utilitarianism, Kantian Ethics, and Rights and
Justice Theories as approaches to ethical decision making.

4.3. Philosophical Approaches to Ethics

In this section we will look at some philosophical approaches to Ethics

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 Corporate Performance, Governance, and Business Ethics IFT Notes

The Friedman Doctrine:

This theory states that

 As long as a company stays within the boundaries of law, its only social responsibility is
to increase profits and to maximize the returns to its shareholders.
 Businesses should not carry out social expenditures beyond those required by law or for
efficient running.
 Shareholders can use the returns on their investment for social investments at their own
discretion; however managers of the company should not make this decision for them.

Friedman’s theory fails because laws differ substantially from country to country. Usually
developing countries have lenient or no laws as compared to developed countries for child labor,
pollution etc. However it is still immoral to engage in these practices.

Utilitarian and Kantian Ethics:

This theory states that:

 Actions have multiple consequences, some that are good for society and some that are
bad.
 An action can be considered desirable if the good consequences are greater than the bad
consequences.
 Companies need to carefully weigh the social benefits and costs of a business action and
pursue only those actions where the benefits outweigh the costs.
 The best decisions are those that produce the greatest good for the greatest number of
people.

Drawbacks of this theory:

 Often benefits and costs cannot be measured.
 It does not consider justice. Greatest good for a large number of people cannot come at
the expense of unjustified treatment of a minority.

Kantian ethics are based on the philosophy that people should be treated as ends and never
purely as means to the ends of others. People are not instruments or machines. People have
dignity and need to be respected as such. Although this theory is incomplete, most of the world
still considers the notion that people should be respected and treated with dignity.

Rights Theories:

These theories state that:

 Human beings have fundamental rights and privileges.
 Rights establish a minimum level of morally acceptable behavior and trump a collective
good.
 Fundamental human rights form the moral compass that managers should use while
making ethical decisions.

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 Corporate Performance, Governance, and Business Ethics IFT Notes

 As stated earlier under the stakeholder theory, stakeholders have basic rights that should
be respected, and it is unethical to violate those rights.

It is important to note that along with rights come obligations. Certain people or institutions are
obligated to provide benefits or services that secure the rights of others. Sometimes such
obligation may fall on more than one moral agent.

Justice Theories:

This theories state that:

 We should focus on a just distribution (one that is considered fair and equitable) of
economic goods and services.
 All goods and services should be distributed equally except when an unequal distribution
would work to everyone’s advantage.

According to this theory, valid principles of justice are those, where everyone would agree if
they considered the situation freely and impartially. Impartiality is guaranteed by a concept
called the veil of ignorance. Under this concept everyone is imagined to be ignorant of all their
particular characteristics, for example, their race, sex, intelligence, nationality, family
background, and special talents.

People would then design a system with two fundamental principles of justice.
1. Maximum amount of basic liberty for all (right to vote, freedom of speech, right to hold
property, etc.)
2. Once equal basic liberty is ensured, inequality in social goods (income, wealth, and
opportunities) is allowed if it benefits everyone. This is called the difference principle
and it states that inequalities are justified if they benefit the position of the least
advantaged person.

Veil of ignorance is a conceptual tool that helps define the moral compass managers can use to
navigate through difficult ethical dilemmas.

4.4. Behaving Ethically

Managers should do at least seven things to ensure that basic ethical principles are adhered to:
1. Favor hiring and promoting people with a good sense of personal ethics.
2. Build an organizational culture that places a high value on ethical behavior.
3. Make sure that leaders within the business not only emphasize ethical behavior but also
act ethically themselves.
4. Put decision-making processes in place that require people to consider the ethical side of
business decisions.
5. Hire ethics officers. They ensure that all employees are trained to be ethically aware, and
that the company’s code of ethics is adhered to.
6. Put strong governance processes in place to ensure managers do not engage in self-
dealings and information manipulation.
7. Act with moral courage. This enable managers to walk away from decisions that are

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 Corporate Performance, Governance, and Business Ethics IFT Notes

profitable but unethical, gives employees the strength to say no to instructions that are
unethical.

5. Summary
LO.a: Compare interests of key stakeholder groups and explain the purpose of a
stakeholder impact analysis.

The interests of key stakeholder groups are:

 Stockholders provide risk capital and in exchange expect a return on their investment.
 Creditors also provide capital in the form of debt and in exchange expect to be repaid on
time with interest.
 Employees provide labor and skills and in exchange expect compensation, job security,
job satisfaction and good working conditions.
 Customers provide revenues and in exchange want products and services that are value
for money.
 Suppliers provide input materials and in exchange want revenues and reliable buyers.
 Governments provide rules and regulations and in exchange want companies to follow
these rules.
 Unions provide companies with productive employees and in exchange want benefits for
their members
 Local communities provide local infrastructure and in exchange want companies to be
responsible citizens.
 General public provides national infrastructure and in exchange want assurance that
company will help improve the quality of life.

Stakeholders may have conflicting demands. For example, union claims for high wages can
conflict with customer demand for low prices and stockholder demands for high returns.
Companies, therefore, cannot satisfy the claims of all stakeholders. Hence, companies need to
identify the most important stakeholders and give highest priority to follow strategies that fulfill
their needs. Stakeholder impact analysis is used for such identification.

LO.b: Discuss problems that can arise in principal–agent relationships and mechanisms
that may mitigate such problems.

Agency problems arise when the goals of agents are different from the goals of principals and
there is information asymmetry. Agents usually have more information about their projects than
principals. Some agents can take advantage of this and take actions that are not in the best
interest of their principals. To prevent this, principals may put the following mechanisms in place
to monitor agents:
 Board of Directors
 External Audits
 Internal Audits

LO.c: Discuss roots of unethical behavior and how managers might ensure that ethical

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 Corporate Performance, Governance, and Business Ethics IFT Notes

issues are considered in business decision making.

The following generalizations can be made about the roots of unethical behavior:
1. Business ethics go hand in hand with personal ethics. An individual with a strong sense
of personal ethics is less likely to behave in an unethical manner in a business setting.
2. At times businesspeople act unethically simply because they fail to ask the relevant
question: Is this decision or action ethical? They do not consider the ethical aspect of
their decisions.
3. Sometimes organizations de-emphasize business ethics and consider only economic
factors
4. There is often pressure from top management to meet performance goals
5. Unethical Leadership: If leaders do not behave in an ethical manner, employees might not
either.

Managers should do at least seven things to ensure that basic ethical principles are adhered to:
1. Favor hiring and promoting people with a good sense of personal ethics.
2. Build an organizational culture that places a high value on ethical behavior.
3. Make sure that leaders within the business not only emphasize ethical behavior but also
act ethically themselves.
4. Put decision-making processes in place that require people to consider the ethical side of
business decisions.
5. Hire ethics officers. They ensure that all employees are trained to be ethically aware, and
that the company’s code of ethics is adhered to.
6. Put strong governance processes in place to ensure managers do not engage in self-
dealings and information manipulation.
7. Act with moral courage. This enable managers to walk away from decisions that are
profitable but unethical, gives employees the strength to say no to instructions that are
unethical.

LO.d: Compare the Friedman doctrine, Utilitarianism, Kantian Ethics, and Rights and
Justice Theories as approaches to ethical decision making.

The Friedman Doctrine:

 As long as a company stays within the boundaries of law, its only social responsibility is
to increase profits and to maximize the returns to its shareholders
 Businesses should not carry out social expenditures beyond those required by law or for
efficient running.
 Shareholders can use the returns on their investment for social investments at their own
discretion; however managers of the company should not make this decision for them.

Utilitarian and Kantian Ethics:

 Actions have multiple consequences, some that are good to society and some that are bad
to society.
 An action can be considered desirable if the good consequences are greater than the bad
consequences.
 Companies need to carefully weigh all the social benefits and costs of a business action

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 Corporate Performance, Governance, and Business Ethics IFT Notes

and pursue only those actions where the benefits outweigh the costs.
 The best decisions are those that produce the greatest good for the greatest number of
people.

Rights Theories:
 Human beings have fundamental rights and privileges.
 Rights establish a minimum level of morally acceptable behavior and trump a collective
good.
 Fundamental human rights form the moral compass that managers should use while
making ethical decisions.
 As stated earlier under the stakeholder theory, stakeholders have basic rights that should
be respected, and it is unethical to violate those rights.

Justice Theories:
 We should focus on a just distribution (one that is considered fair and equitable) of
economic goods and services.
 All goods and services should be distributed equally except when an unequal distribution
would work to everyone’s advantage.

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