Strategic Management Concepts and Cases Competitiveness and Globalization 10th Edition Hitt Solutions Manual

Chapter 10: Corporate Governance
Chapter 10
Corporate Governance
KNOWLEDGE OBJECTIVES
1. Define corporate governance and explain why it is used to monitor and control top-level
managers’ decisions.
2. Explain why ownership is largely separated from managerial control in organizations.
3. Define an agency relationship and managerial opportunism and describe their strategic
implications.
4. Explain the use of three internal governance mechanisms to monitor and control
managers’ decisions.
5. Discuss the types of compensation executives receive and their effects on managerial
decisions.
6. Describe how the external corporate governance mechanism—the market for corporate
control—restrains top-level managers’decisions.
7. Discuss the nature and use of corporate governance in international settings, especially in
Germany, Japan, and China.
8. Describe how corporate governance fosters the making of ethical decisions by a firm’s
top-level managers.
CHAPTER OUTLINE
Opening Case Corporate Governance: What Is All the Fuss About?

SEPARATION OF OWNERSHIP AND MANAGERIAL CONTROL
Agency Relationships
Product Diversification as an Example of an Agency Problem
Agency Costs and Governance Mechanisms
OWNERSHIP CONCENTRATION
The Increasing Influence of Institutional Owners
BOARD OF DIRECTORS
Enhancing the Effectiveness of the Board of Directors
Executive Compensation
The Effectiveness of Executive Compensation
Strategic Focus Executive Compensation: What Are Some of the Issues and What Might
the Future Hold?
MARKET FOR CORPORATE CONTROL
Managerial Defense Tactics
INTERNATIONAL CORPORATE GOVERNANCE
Corporate Governance in Germany and Japan
Corporate Governance in China
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GOVERNANCE MECHANISMS AND ETHICAL BEHAVIOR

Strategic Focus The Many Facets of Corporate Governance: Rio Tinto’s Experiences
SUMMARY
REVIEW QUESTIONS
EXPERIENTIAL EXERCISES
VIDEO CASE
NOTES
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-serving (working for the best interests of
managers only, to the detriment of shareholders). In the absence of effective
internal governance mechanisms, the market for corporate control—an
external governance mechanism—may be activated. Though it is a subject
most frequently associated with firms in the US and the U.K., the
effectiveness of governance is gaining attention throughout the world. The
chapter begins by describing the relationship that provides the foundation on
which the modern corporation is built—i.e., the relationship between owners
and managers. However, the majority of this chapter is devoted to an
explanation of various mechanisms owners use to govern managers and
ensure maximization of shareholder value.
OPENING CASE
Corporate Governance: What Is All the Fuss About?
The focus of the Opening Case provides an overview of some of the issues related to
corporate governance. At its core, corporate governance deals with the actions of top-level
managers and the responsibilities of the board of directors to ensure managers are acting in
appropriate ways. Thus, corporate governance is concerned with issues such as organization
effectiveness, transparency, accountability, incentivizing actions, and creating value (for
stakeholders and shareholders). Corporate governance is important to individual companies
because effective governance should result in superior performance. It is also an important
concern to nations because in the global economy, capital flows toward opportunity.
Effective governance is part of the equation for ensuring competitiveness and, subsequently,
acceptable returns.
Teaching Note: Effective corporate governance has been a critical issue for the
past several decades. Unfortunately, minimal real progress has been made in
this area. For all the grand gestures and corporate/governmental assurances,
effectiveness, transparency, accountability, use of incentives, and value creation
all have a lot of room for improvement. Ask students to identify contemporary
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governance issues/governance breakdowns and to speculate about why the

issue/breakdown exists. Ask them to identify the weak points in the system.
Though students are probably unfamiliar with governance systems in other
countries, they should realize that effective governance is a global concern, not
just a national one.
Define corporate governance and explain why it is used to

1
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
organizations. At its core, corporate governance is concerned with identifying ways to ensure
that strategic decisions are made effectively.
Corporate governance has been emphasized in recent years because, as the opening case
illustrates, corporate governance mechanisms increasingly affect all stakeholders and the
firm's future.
Effective corporate governance is also of interest to nations. Governments want firms

operating within their countries to grow and provide employment, wealth, and satisfaction.
This raises standards of living and enhances social cohesion.
Three internal governance mechanisms examined here are (1) ownership concentration, as
represented by types of shareholders and their different incentives to monitor managers, (2)
the board of directors, and (3) executive compensation. The external governance mechanism
is the market for corporate control.
Teaching Note: In the chapter, corporate governance is discussed from two

perspectives:
• The primary purpose of governance mechanisms is to prevent severe
problems that may occur because of the separation of ownership and
control in large firms by positively influencing managerial behavior.
• The ability of governance mechanisms to direct top mangers’ actions
toward shareholder objectives is dependent on the correct combination of
mechanisms being used.
Explain why ownership is largely separated from

2
managerial control in organizations.
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.
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Shareholders make investments by purchasing stock (representing ownership), which entitles

them to a share of the firm’s residual income (or profits) that remain after all expenses have
been paid.
• The right to share in residual income also means that shareholders also must accept the
risk that no residual profits will remain if the firm’s expenses exceed its income.
• Shareholders can manage investment risk by investing in a diversified portfolio of firms.
• In small firms, managers and owners are often one in the same—less separation of
ownership and control.
• As family-controlled firms grow, the owners generally do not have sufficient capital or
managerial skills to grow the business and seek other sources of capital and skills to
support this expansion.
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 students to see that Henry Ford was
involved in both the ownership and the operation of Ford Motor Company in
the early days. They can see in their minds the old footage of Model T’s
coming off a very crude assembly line, by today’s standards, and understand
how much simpler operations were at the time. That has all changed with the
advent of the modern, complex corporation. Today there is almost no way to
bring ownership and managerial control back together again in a workable
model.
Define an agency relationship and managerial opportunism

3
and describe their strategic implications.
Agency Relationships
Although the efficient separation of ownership and control enables specialization both 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 to
another party (the agent[s]) in return for compensation as a decision-making specialist who
performs a service. This relationship can be broader than just owners and managers—e.g.,
consultants and clients or insured and insurer.
Figure Note: Figure 10.1 illustrates how separation of ownership from control
results in an agency relationship and is very helpful in getting students to
understand the issues involved.
FIGURE 10.1
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An Agency Relationship
Note the following in the figure (Figure 10.1):

• Shareholders (principals) hire managers (agents) as decision makers.
• The hiring act creates an agency relationship wherein a risk-bearing specialist (principal)
compensates a managerial decision-making specialist (agent).
The potential for conflicts of interests between owners and managers is created by the
delegation of the responsibilities of decision making to managers. Therefore, managers may
take actions that are not in the best interests of owners by selecting strategic alternatives that
serve managerial interests rather than shareholder or owner interests.
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.
Before observing the results of decisions, it is impossible to know which agents will behave
opportunistically and which ones will not because a manager’s reputation is an imperfect
guide to future behavior. As a result, principals establish governance and control mechanisms
because the opportunity for opportunistic behavior and conflicts of interest exists.
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.
Managers may pursue higher levels of product diversification than are desired by
shareholders to capture the value of opportunities that are available to managers, but not to
owners.
• 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 can reduce managerial employment risk (the risk of job
loss, loss of compensation, or loss of managerial reputation). Increased diversification
reduces managerial employment risk because the firm (and the manager) is less affected
by a reduction in demand for (or failure of) a single product line when the firm produces
and sells multiple products.
• 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.
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Figure Note: Figure 10.2 illustrates the variance between the risk profiles of
shareholders and managers based on the level or type of firm diversification.
It shows that owners may benefit from managers’ decisions to diversify the
firm’s products, but only to the point where investment returns at the margin
are no longer positive. That is, diversification is valuable to (and preferred by)
owners as long as it has a positive effect on firm value. However, some firms
may be overdiversified, despite the lack of profitability in their dominant
business. Owners also may prefer that excess funds be returned to them in
the form of dividends so they can control reinvestment decisions.
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 diversification. The
optimum risk level is at point A, between dominant business and related-constrained
diversification.
Curve M represents the managerial employment risk profile. It spans a diversification profile
from related-constrained to unrelated diversification. The optimum diversification level for
managers is point B, between related-linked and unrelated businesses.
As illustrated by the S-curve (owner business risk preference) and M-curve (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.
• Owners’ optimum level of diversification is where the S curve turns up, a point between
dominant business and related-constrained diversification.
• Managers prefer a greater scope of diversification than owners. As can be seen from the M
curve in Figure 10.2, managers prefer that the firm’s diversification be between related-
linked and unrelated diversification.
• However, as the curve indicates, there is a point at which managerial employment risk
increases as the firm overdiversifies (as discussed in Chapter 6).
• The optimum level of firm diversification from a managerial risk perspective is at point B
on the M curve, somewhere between related-linked and unrelated businesses.
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.
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For firm diversification to approach the shareholder optimum (point A on curve S in Figure
10.2), managerial autonomy must be controlled by the firm’s board of directors or by other
governance mechanisms that encourage managers to make strategic decisions that are in the
best interests of shareholders.
Agency costs are the sum of incentive, monitoring, and enforcement costs as well as any
residual losses incurred by principals because it is not possible for principals to guarantee
100 percent compliance through monitoring arrangements.
Research suggests that 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 in regard to the impact on strategy formulation and
implementation. That is, because of more intense governance, firms may make decisions that
are much less risky and thus decrease potential shareholder wealth significantly due to the
implementation of SOX.
Explain the use of three internal governance mechanisms to

4
monitor and control managers’ decisions.
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 five percent of the firm’s
shares.
Diffuse ownership (a large number of shareholders with small holdings and few/no large-
block shareholders)
• Produces weak monitoring of managerial decisions
• Makes it difficult for owners to coordinate their actions effectively
• May result in levels of diversification that are beyond the optimum level desired by
shareholders (especially when this condition is combined with weak monitoring)
The Increasing Influence of Institutional Owners
In recent years, large-block ownership by individuals has declined, but they have 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.
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The importance of institutional owners is indicated by the fact that these shareholders now
control over 50 percent of the stock in large US corporations and approximately 56 percent
of the stock of the 1,000 largest US corporations. These ownership percentages suggest that
as investors, institutional owners have both the size and the incentive to discipline ineffective
top-level managers and can significantly influence a firm’s choice of strategies and overall
strategic decisions. Initially, these shareholder activists and institutional investors
concentrated on the performance and accountability of CEOs and contributed to the ouster of
a number of them. They are now targeting what they believe are ineffective boards of
directors.
The rising tide of shareholder pressure also is evidenced by actions taken by CalPERS.
• CalPERS provides retirement and health coverage to over 1.3 million current and retired
public employees.
• CalPERS is generally thought to act aggressively to promote decisions and actions that it
believes will enhance shareholder value in companies in which it invests.
• Institutions’ activism may not have a direct effect on firm performance, but its influence
may be indirect through its effects on important strategic decisions.
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 salary for a specified period of time in the
event of a takeover and the loss of one’s job. A golden goodbye provides
automatic payments to top executives if their contracts are not renewed,
regardless of the reason for nonrenewal. In the case of acquisitions,
managers may receive this compensation even if they voluntarily decide to
quit. Other defense strategies are described in greater detail in Table 10.2.
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
individual shareholders). Furthermore, large financial institution shareholders—such as
banks—are effectively prevented from having direct ownership of firms and are prohibited
from placing a representative on the boards of directors. These conditions highlight the
importance of boards of directors to corporate governance.
Teaching Note: Legally, the board of directors has broad powers, including:
• Directing the affairs of the organization
• Punishing (disciplining) and rewarding (compensating) managers
• Protecting the rights and interests of shareholders (owners)
Boards are experiencing increasing pressure from shareholders, lawmakers, and regulators to
become more forceful in their oversight role and thereby forestall inappropriate actions by
top executives.
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The board of directors is a group of elected individuals whose primary responsibility is to act
in the owners’ interests by formally monitoring and controlling the corporation’s top-level
executives. If the board of directors is appropriately structured and operates effectively, it can
protect owners from managerial opportunism.
Table Note: Table 10.1 provides characteristics of three classifications of

members of the board of directors: insiders, related outsiders, and outsiders.
These will be useful for students as you discuss board effectiveness.
TABLE 10.1
Classifications of Board of Director 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
counsel, a large customer or supplier, or a close relative of one of the firm’s top-level
managers.
Outsiders are individuals who are independent of the firm. They are neither involved in the
firm’s day-to-day operations, nor do they have other relationships with the firm. An example
of an outsider might be the president of a university or a community volunteer.
Because the primary role of the board of directors is to monitor and ratify major managerial
actions to protect the interests of owners, there is a call by advocates of board reform that
outsiders should represent a significant majority of a board’s membership.
Teaching Note: Outside directors (and boards) are perceived as ineffective

because:
• Insiders dominate the board by limiting the flow of information to outside
directors.
• Outside directors are nominated for board membership by insiders
(primarily by the CEO) and thus are indebted to insiders.
The drawbacks of outside boards:

• Because outside directors do not have day-to-day contact with the ongoing operations of
the firm, they must obtain detailed, in-depth information about the quality of management
decisions. Generally this information is obtained through frequent interactions, often
developed over time, with inside directors (generally, at board meetings).
• In the absence of rich information, boards may be forced to emphasize financial rather
than strategic controls. Potentially, this means that outsider-dominated boards—because
they lack sufficient information—will evaluate managers not on the basis of the
appropriateness of their actions (which the board ratified) but based on the financial
outcomes of those actions.
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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
• Strengthening internal management and accounting control systems
• Establishing and consistently using formal processes to evaluate the board’s performance
• Creating a “lead director” role that has strong powers with regard to the board agenda and
oversight of nonmanagement board member activities
• Changing the director compensation, especially reducing or eliminating stock options as
part of the package
Teaching Note: The following comments can be used to expand the class
discussion of 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, indicating 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.
• Boards are more likely to be involved in strategic decisions when the firm is
smaller and less diversified, since information regarding strategic actions is
more readily available and both the scope and size of the firm are
manageable.
• Boards are less active in large, diversified firms.
• The board’s access to sufficiently rich information on appropriateness of
strategic actions in large diversified firms is limited.
• Board may be limited to evaluating financial outcomes (instead of action
appropriateness).
Teaching Note: McKinsey & Co. research found that institutional

shareholders were willing to pay an 11 percent premium for the shares of
companies when outsiders constitute a majority of the board, own significant
amounts of stock, are not personally tied to top management, and when
management is subjected to formal evaluation.
Research shows that boards working collaboratively with management:

• Make higher quality strategic decisions
• Make decisions faster
• Become more involved in the strategic decision-making process
Because of the increased pressure from owners and the potential conflict among board
members, procedures are necessary to help boards function effectively in facilitating the
strategic decision-making process.
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Increasingly, outside directors are being required to own significant equity stakes as a
prerequisite to holding a board seat. In fact, some research suggests that firms perform better
if outside directors have such a stake.
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 process to strongly
influence the selection of new members.
Discuss the types of compensation executives receive and

5
their effects on managerial decisions.
Executive Compensation
As illustrated in the opening case and Strategic Focus, the compensation of top-level
managers generates great interest and strongly held opinions. One reason for this widespread
interest can be traced to a natural curiosity about extremes and excesses. But furthermore,
CEO pay is an indirect but tangible way to assess governance processes in large corporations.
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.
Sometimes the use of a long-term incentive plan prevents major stockholders (e.g.,
institutional investors) from pressing for changes in the composition of the board of directors,
because they assume that long-term incentives ensure that top executives will 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.
Using executive compensation as a governance mechanism is more challenging in

international firms. Evidence suggests that the interests of owners of multinational
corporations may be served best when the firm’s foreign subsidiary compensation plans are
customized to local conditions. Though unique compensation plans require additional
monitoring and increase the firm’s agency costs, it is important to adjust pay levels to match
those of the region of the world (e.g., higher in the US and lower in Asia).
Teaching Note: When DaimlerBenz acquired Chrysler, it highlighted the fact

that top executives at Chrysler made much more than the executives at
DaimlerBenz—but higher-paid Chrysler executives report to lower-paid
Daimler bosses. This example is one that students seem to be able to grasp.
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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.
• Decisions made by top-level managers are likely to affect firm performance over an
extended period of time. As a result, it is difficult to assess the effect of current decisions
using current period performance.
• Many variables (or outside factors) intervene between management behavior and firm
performance (e.g., uncontrollable shifts in the environment).
Although incentive compensation plans may increase the value of a firm in line with
shareholder expectations, such plans are subject to managerial manipulation.
Although long-term performance-based incentives may reduce temptations to under-invest in

the short run, they increase executive exposure to risks associated with uncontrollable
events—e.g., market shifts, industry decline.
The Effectiveness of Executive Compensation
The compensation received by top-level managers, especially by CEOs, is often a subject of

controversy.
Large CEO compensation packages result mostly from the inclusion of stock options and
stock in the total pay packages. This is intended to entice executives to keep the stock price
high, thus aligning manager and owner interests.
Research has shown that managers owning more than one percent of the firm’s stock are less
likely to be forced out of their jobs, even when the firm is performing poorly.
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: One way that boards have found to compensate executives
is through giving them loans with favorable, or no, interest for the purpose of
buying company stock. If done correctly, this can be a governance tool, since
it aligns executives’ priorities with those of the shareholders because the
executives hold stock, not just options on the stock. They gain or lose money
along with the shareholders.
It is important to consider that annual bonuses may provide incentives to pursue short-run
objectives at the expense of the firm’s long-term interests.
Although some stock-option-based compensation plans are well designed with option strike
prices substantially higher than current stock prices, too many have been designed simply to
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give executives more wealth that will not immediately show up on the balance sheet.
Research of stock option repricing where the strike price value of the option has been
lowered from its original position suggests that action is taken more frequently in high-risk
situations. However, it also happens when firm performance was poor to restore the incentive
effect for the option. Often, organizational politics play a role in this.
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.
Interestingly, institutional investors prefer compensation schemes that link pay with
performance, including the use of stock options. Again, this evidence shows that no internal
governance mechanism is perfect.
Option awards became a means of providing large compensation packages, and the options
awarded did not relate to the firm’s performance, particularly when boards showed a
propensity to reprice options at a lower strike price when stock prices fell precipitously.
Option awards are becoming increasingly controversial.
Teaching Note: Board directors also receive compensation. Some recent

figures follow:
• Median base compensation for directors in telecommunications was almost
$90,000.
• Directors at Microsystem Inc. received average compensation of about
$410,000 a year, whereas directors at Compaq earned over $360,000 and
directors at Pfizer received almost $260,000.
• On average, directors at the largest 200 firms received about $134,000.
• Similar to executives in the firm, there is a move by large institutional
investors such as CalPERS to pay directors at least partially in stock (some
estimating that some 50 percent of director pay will be in company stock).
STRATEGIC FOCUS
Executive Compensation: What Are Some of the Issues and What Might the Future
Hold
The Strategic Focus notes that executive pay (especially in the US) is a very controversial
topic. In 2010 CFO pay varied from $600,000 to more than $60 million, with five CFO’s
receiving over $20 million. For the CEOs of 350 major companies, pay was up 10.7 percent
to $9.27 million. A recent survey of a broad cross-section of the labor force showed that 77
percent believe the CEOs are overpaid. Incentivizing top-level executives is fraught with
problems. Executives believe that too often pay is tied to short-term, rather than long-term
performance. Compensation consultant Graf Crystal conducted an analysis and concluded
that there is NO relationship between shareholder returns and CEO compensation. The
question then becomes how to incentivize CEOs in a way that aligns their interests to those
of shareholders.
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Teaching Note: Most students will have an opinion about executive pay. Ask how
many students believe executives are paid too much, too little, or are fairly
compensated for what they do. Ask proponents of each side to provide some
justification for their positions. Point out that numerous examples exist in which
executives received handsome pay increases even though their companies lost
value (hurting shareholders) and earnings were down. Ask students how they
think executive pay should be structured so that executives are fairly paid. Ask
students how effective they think of the board of directors and executive
compensation are as a governance mechanism in light of the situation.
Describe how the external corporate governance mechanism—

6 the market for corporate control—restrains top-level
managers’decisions.
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
The market for corporate control has been active for some time. The 1980s were known
as 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 value
of mergers and acquisitions in that decade was more than $10 trillion. The major
reduction in the stock market resulted in a significant drop in acquisition activity in the
first part of the 21st century. However, the number of mergers and acquisitions began to
increase in 2003, and the market for corporate control has become increasingly
international with over 40 percent of the merger and acquisition activity involving two
firms from different countries.
Though some acquisition attempts are intended to obtain resources important to the
acquiring firm, most of the hostile takeover attempts are due to the target firm’s poor
performance. Therefore, target firm managers and members of the boards of directors
are highly sensitive about hostile takeover bids. It often means that they have not done
an effective job managing the company because of the performance level inviting the
bid. If they accept the offer, they are likely to lose their jobs; the acquiring firm will
insert its own management. If they reject the offer and fend off the takeover attempt,
they must improve the performance of the firm or risk losing their jobs as well.
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 in order to
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form a new division in an established diversified firm, merge two previously separate firms,
and usually replace the target firm’s management team to revamp the strategy that caused
low firm performance.
The market for corporate control governance mechanism should be triggered by a firm’s poor
performance relative to industry competitors. A firm’s poor performance, often demonstrated
by the firm’s earning below-average returns, is an indicator that internal governance
mechanisms have failed; that is, their use did not result in managerial decisions that
maximized shareholder value.
Managerial Defense Tactics
Because of the threat of dismissal, managers have devised a number of defensive tactics
designed to both ward off takeovers and buffer or protect managers from external governance
mechanisms. These tactics include:
• Managerial pay interventions, such as golden parachutes
• Asset restructuring, such as divesting a business unit or division
• Financial restructuring—e.g., stock repurchases, paying out a firm’s free cash flows as a
dividend
• Changing the state of incorporation
• Making targeted shareholder repurchases (known as greenmail)
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, inconclusive).
The defense strategies mentioned are poison pill, corporate charter amendment, golden
parachute, litigation, greenmail, standstill agreement, and capital structure change.
Most institutional investors oppose the use of defense tactics. For example, TIAA-CREF and
CalPERS have taken actions to have several firms’ poison pills eliminated.
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
• Expensive defensive strategies were often implemented to protect the firm
Despite its inefficiency, the threat of acquisition by corporate raiders can serve as an
effective constraint on the managerial growth motive and result in strategies that are in the
best interests of the firm’s owners.
10-15
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.
Discuss the nature and use of corporate governance in

7 international settings, especially in Germany, Japan, and
China.
INTERNATIONAL CORPORATE GOVERNANCE
Our discussion of internal and external governance mechanisms—and their effectiveness in

controlling managerial behavior—has been centered on the US and the U.K. But this does
not necessarily apply to the systems of corporate governance used elsewhere in the world,
e.g., German and Japanese firms.
Although the stability that has been associated with the German and Japanese systems has
been perceived as a strength, it is possible, given the dynamic and uncertain nature of the
new competitive landscape, that stability may be a potential source of weakness.
Corporate Governance in Germany and Japan
The owner-manager relationship in Germany differs from that described for the US. For
example:
• In many private German firms, the owner and manager are the same person.
• In publicly traded firms there often is a dominant shareholder.
Banks historically have occupied a central position in German governance structure.

• Banks became major shareholders when companies they financed either sought new
capital in the stock market or defaulted on loans.
• Banks generally hold less than 10 percent of a firm’s stock.
• Bank ownership of a single firm’s stock is limited to 15 percent of the bank’s capital.
• Three large banks—Deutsche, Dresdner, and Commerzbank—hold majority positions in
large German firms through their own holdings and proxy votes for shareholders who
retain shares with the banks.
• German firms with more than 2,000 employees must have a two-tiered board structure,
with supervision of management being separated from other board duties and all of the
functions of direction and management being placed in the hands of the Vorstand or
management board.
• Appointment to the management board is the responsibility of the Aufsichtsrat or
supervisory board.
10-16
Despite the ability of major owners and banks to monitor and control the managers of large
German firms, maximizing shareholder value has not been a historical focus. However, this
is changing.
Teaching Note: A shift is taking place in German firms’ historic lack of focus
on maximizing shareholder value. For example, SGL Carbon AG lost more
than $71 million in the early 1990s and was later restructured to turn the
corporation around. In particular the firm’s governance structure was
changed, transparent accounting practices were adopted, and the firm set a
goal of enhancing shareholder value. The firm’s performance has since
improved, and many attribute this to the new governance structure.
Corporate governance in Japan is affected by the concepts of obligation, family, and

consensus.
In Japan, obligation goes beyond principles but is more a product of specific causes, events,
and relationships. It can mean returning a service for one that has been rendered.
The concept of family goes beyond the American concept to include the firm—individuals
see themselves as members of a company family. And the family concept is extended to
include members of the firm’s keiretsu, a group of firms that are tied together by cross-
shareholdings, interrelationships, and interdependencies.
Consensus represents one of the most important influences on governance structure in Japan.
This requires that managers—among others—expend significant amounts of energy to win
the hearts and minds of people rather than proceed by the edicts of top-level managers.
As in Germany, banks also play an important role in financing and monitoring large public
firms in Japan.
• The bank owning the largest share of stocks and the largest amount of debt—the main
bank—has the closest relationship with the company’s top executives.
• Banks occupy an important position in the governance system, both financing and
monitoring firms.
• The main bank—the bank holding the largest share of a firm’s debt—provides financial
advice and assumes primary responsibility for monitoring the firm’s management.
• Japanese banks can hold up to five percent of a firm’s stock.
• Groups of banks can hold up to 40 percent of a firm’s stock.
• In many cases, bank relations are an integral part of the Japanese firm’s keiretsu (an
industrial group of firms that interact with the same bank).
Teaching Note: Keiretsus are both diversified and vertically integrated to the
extent that they generally include one or more firms in almost all important
industrial sectors.
As in Germany, Japan’s corporate governance structure is changing. For example, the role of
banks in the monitoring and control of managerial behavior and firm outcomes has become
less significant.
10-17
Corporate Governance in China
Corporate governance in China has undergone major changes over the past decade, along
with the privatization of business and the development and integrity of the equity market.
Though these changes are significant, the state still dominates the strategies that most firms
employ. Research indicates that firms with higher state ownership have lower market value
and more volatility than those with less. This is due to the fact because the state imposes
social goals on these firms and executives are not trying to maximize shareholder wealth.
Overall, the Chinese system of corporate governance has been moving toward a Western-
style model. Chinese executives are also being compensated based on the firm’s financial
performance.
Teaching Note: Examples of differences and changes in international

governance follow:
• In France, anger has been growing over the lack of information on top
executive compensation. A recent report recommended that the positions
of CEO and chairman of the board be held by two different individuals. It
also recommended reducing the tenure of board members and disclosing
their pay.
• In South Korea, principles of corporate governance are being adopted to
provide proper board and management incentives to pursue the interests of
both the company and the shareholders and to facilitate effective
monitoring.
• Changes in corporate governance are occurring even in transitional
economies, such as China and Russia, though implemented more
gradually. The use of stock-based compensation plans has influenced
foreign companies to invest (particularly in China).
Describe how corporate governance fosters the making of

8
ethicaldecisions by a firm’s top-level managers.
GOVERNANCE MECHANISMS AND ETHICAL BEHAVIOR
Governance mechanisms discussed in this chapter focus on ensuring that managers work
effectively toward meeting their obligation to maximize shareholder wealth. However,
shareholders are only one group of the firm’s stakeholders (as discussed in Chapter 1).
Over the long term, the demands of other key stakeholders—such as employees, customers,
suppliers, and the community—also must be satisfied in order to maximize shareholder
wealth.
10-18
For that reason and others, governance mechanisms must be carefully designed and
implemented so that managers’ attention is not focused on maximizing short-term returns and
to ensure that they consider the interests of all stakeholders.
Teaching Note: John Smales (outside director of the board at GM) has
commented that the most fundamental obligation of management is to
perpetuate the organization, taking priority even over stockholder interests.
His comments may provide a good opportunity to engage students in a
discussion about the purpose of the firm and its obligations to all
stakeholders.
STRATEGIC FOCUS
The Many Facets of Corporate Governance: Rio Tinto’s Experiences
Rio Tinto is a leading international mining group with multiple products and operations
spread across the globe. Rio Tinto’s espoused governance values include accountability,
respect, teamwork, and integrity. However, its governance has been challenged. For example,
large-block pension funds supported union-backed resolutions for the appointment of a single
independent non-executive deputy chairman and for the firm to adopt the International
Labour Organisation’s conventions concerning human rights conditions and practices at
worksites. In addition, executive compensation has come under fire with critics claiming that
executives received generous bonuses for hitting unchallenging targets. All of these aspects
are worth investigating. On the plus side, however, Rio Tinto has been a strong supporter of
“whistleblower” protection. Rio Tinto’s corporate governance is complicated by both the
scope and scale of its operations but it should be a priority to ensure effective performance in
the years to come.
Teaching Note: Students may be unfamiliar with Rio Tinto but there are a couple
of points that students could take away from a discussion of the company. First,
although Rio Tinto has developed a Governance Standards Manual, it is prudent
in matters such as this to “trust but verify.” Words in a manual are one thing but
actions and results can be another. The company should ultimately stand by what
it does, not what it says it is going to do. Second, students should understand that
corporate governance is a complex topic that has several dimensions, many of
them highlighted in this case. Have them read the chapter, then ask them to
identify other salient dimensions.
— ANSWERS TO REVIEW QUESTIONS
1. 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? (pp. 294–295)
10-19
Corporate governance is a relationship among stakeholders that is used to determine and

control the direction and performance of organizations.
Corporate governance receives a great deal of attention because governance mechanisms

sometimes fail to adequately monitor and control top-level managers’ strategic decisions. If
the behavior of top-level mangers is not monitored and controlled effectively, this could
mean that the firm will not be strategically competitive.
Effective corporate governance is also of interest to nations. A country prospers as its firms
grow and provide employment, wealth, and satisfaction—thus improving standards of living.
These aspirations are met when firms are competitive internationally in a sustained way.
Corporate governance reflects the standards of the company, which collectively reflect
societal standards. Thus, in many corporations, shareholders attempt to hold top-level
managers more accountable for their decisions and the results they generate. As with
individual firms and their boards, nations that govern their corporations effectively may gain
a competitive advantage over rival countries.
As owners delegate strategy development and decision making to managers, conflicts of

interest emerge—managers may select strategic alternatives that serve their own best
interests, not those of the owners. Governance mechanisms help owners (shareholders)
ensure that managers make strategic decision that are in the best interests of the former. If
internal governance mechanisms are ineffective, the market for corporate control (an external
governance mechanism) may be activated.
2. What is meant by the statement that ownership is separated from managerial

control in the corporation? Why does this separation exist? (pp. 295–296)
Historically, US firms were managed by the founders/owners and their descendants. In these
cases, corporate ownership and control resided in the same person(s). As firms grew larger,
ownership and control were separated in most large corporations so that control of the firm
shifted to professional managers while ownership was dispersed among unorganized
stockholders who were removed from day-to-day management. These changes created the
modern public corporation, which is based on the efficient separation of ownership and
managerial control. 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
financial gains of the owners (or shareholders). However, this right also requires that they
accept the financial risk of the firm and its operation.
As shareholders diversify their investments over a number of corporations, their risk declines
(the poor performance or failure of any one firm in which they invest has less overall effect).
Shareholders thus specialize in managing their investment risk while managers focus on
decision making. Without management specialization in decision making and owner
specialization in risk bearing, a firm probably would be limited by the abilities of its owners
to manage and make effective strategic decisions. Therefore, in concept, the separation and
specialization of ownership (risk bearing) and managerial control (decision making) should
produce the highest returns.
10-20
3. What is an agency relationship? What is managerial opportunism? What

assumptions do owners of corporations make about managers as agents? (pp. 296–
299)
Despite its advantages, the separation of ownership and control may result in some potential
costs (and risks) for owners by creating an agency relationship. An agency relationship exists
when one or more persons (the principal or principals) hires another person or persons (the
agent or agents) as a decision-making specialist to perform a service. In other words, the
agency relationship exists when one party delegates decision making to another party in
return for compensation.
The owner-agent relationship enables the possibility of managerial opportunism, the seeking
of self-interest with guile (i.e., cunning or deceit) where opportunism is represented by an
inclination toward self-seeking behaviors. However, before observing the results of
decisions, it is impossible to know which agents will behave opportunistically and which
ones will not. A manager’s reputation is an imperfect guide to future behavior and
opportunistic behavior cannot be observed until after it has occurred.
4. 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? (pp. 299–306)
Ownership concentration is an effective governance mechanism because owners of large

blocks of stock (representing a higher percentage of ownership) have a greater financial
interest in monitoring managerial decisions than do small shareholders (characterized as
diffuse ownership). Increasingly, institutional investors such as stock mutual funds and
public-pension funds hold large blocks of stock, and these shareholders aggressively monitor
and take action against managers who receive excessive compensation and perks but achieve
only poor firm performance.
Monitoring and controlling managerial decisions are supposed to be accomplished through

the firm’s board of directors, members of which are elected by shareholders to oversee
managers and ensure that the firm is operated in the best interests of owners. Members can be
classified into three categories—insiders (the CEO and other top-level managers), related
outsiders (member who are not involved in day-to-day operations but have some relationship
with the firm), and outsiders (members who are independent of the firm and its operations).
Executive compensation can be used to help align the interests of managers and owners by
tying managerial pay to firm performance through salaries, bonuses, and long-term
incentives based on stock options. However, given the complexity and long-term nature of
strategic decisions, it may be difficult to perfectly align compensation with firm performance.
First, the strategic decisions made by top-level managers are typically complex and
nonroutine, so direct supervision of executives is inappropriate for judging the quality of
their decisions. Thus, compensation of top-level managers is usually determined by the
firm’s financial performance. Second, the impact of an executive’s decisions is not
10-21
immediate, making it difficult to assess the effect of decisions on the corporation’s

performance. Third, a number of variables (unpredictable economic, social, or legal changes)
intervene between top-level managerial behavior and firm performance, making it difficult to
discern the effects of strategic decisions.
5. What trends exist regarding executive compensation? What is the effect of the
increased use of long-term incentives on top-level managers’ strategic decisions?
(pp. 305–306)
In recent times, many stakeholders, including shareholders, have been angered by what they
consider the excessive compensation received by some top-level managers, especially CEOs.
The primary reason for such large compensation packages is the inclusion of stock options
and stock in the total pay packages. The primary reasons for compensating executives with
stock is that it provides incentives to keep the stock price high, thus aligning manager and
owner interests. However, there may be some unintended consequences. Research has shown
that managers who own more than one percent of the firm’s stock are less likely to be forced
out of their jobs, even when the firm is performing poorly.
Increasingly, long-term incentive plans are becoming a critical part of compensation

packages in US firms. The use of longer-term pay helps firms cope with or avoid potential
agency problems. Because of this, the stock market generally reacts positively to the
introduction of a long-range incentive plan for top executives.
While some stock option-based compensation plans are well designed with option strike
prices substantially higher than current stock prices, too many have been designed simply to
give executives more wealth that will not immediately show up on the balance sheet.
Research of stock option repricing where the strike price value of the option has been
changed to be lower than it was originally set suggests that step is taken more frequently in
high-risk situations. However, it also happens when firm performance was poor to restore the
incentive effect for the option. But evidence also suggests that organizational politics are
often involved. Additionally, research has found that 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. Interestingly, institutional investors prefer compensation schemes
that link pay with performance, including the use of stock options. Again, this evidence
shows that no internal governance mechanism is perfect.
Whereas stock options became highly popular as a means of compensating top executives
and linking pay to performance, they also have become controversial of late. It seems that
option awards became a means of providing large compensation packages and the options
awarded did not relate to the firm’s performance, particularly when boards showed a
propensity to reprice options at a lower strike price when stock prices fell precipitously.
Because of the large number of options granted in recent years and the increasingly common
practice of repricing them, some have called for expensing the options by the firm at the time
they are awarded. This action could be quite costly to many firms’ stated profits. Thus, some
firms have begun to move away from granting stock options.
10-22
6. What is the market for corporate control? What conditions generally cause this
external governance mechanism to become active? How does this mechanism
constrain toplevel managers’ decisions and actions? (pp. 308–310)
The market for corporate control is an external governance mechanism that becomes active
when a firm’s internal controls fail. The market for corporate control is composed of
individuals and firms that buy ownership positions in (or take over) potentially undervalued
corporations so they can form new divisions in established diversified companies or merge
two previously separate firms. Because they are assumed to be the party responsible for
formulating and implementing the strategy that led to poor performance, the top management
team of the acquired company is usually replaced. Thus, the market for corporate control
disciplines managers that are ineffective or act opportunistically. firm’s poor performance is
an indication that internal governance mechanisms have failed (that is, their use did not result
in managerial decisions that maximized shareholder value), opening the door to the
involvement of the market for corporate control. Indeed, hostile takeovers are the major
activity in the market for corporate control.
7. What is the nature of corporate governance in Germany, Japan, and China? (pp.
310–313)
In many private German firms, owner and manager may be the same individual and thus no
agency problem will exist. Even in publicly traded corporations, there is often a dominant
shareholder, so the problem is minimized. Thus, ownership concentration is an important
means of corporate governance in Germany, just as it is in the US.
Historically, banks have been at the center of the German corporate governance structure,
which is the case in many continental European countries such as Italy and France. As
lenders, banks become major shareholders when companies they had financed earlier seek
funding on the stock market or default on loans. Although stakes are usually under 10
percent, there is no legal limit on how much of a firm’s stock banks can hold (except that a
single ownership position cannot exceed 15 percent of the bank’s capital). Shareholders can
tell the banks how to vote their ownership position, but they generally elect not to do so.
Banks monitor and control managers both as lenders and as shareholders by electing
representatives to supervisory boards.
German firms with more than 2,000 employees are required to have a two-tier board
structure. Through this structure, the supervision of management is separated from other
duties normally assigned to a board of directors, especially the nomination of new board
members. Thus, Germany’s two-tiered system places the responsibility to monitor and
control managerial (or supervisory) decisions and actions in the hands of a separate group.
Though all the functions of direction and management are the responsibility of the
management board, appointment to this body is the responsibility of the supervisory tier.
Employees, union members, and shareholders appoint members to the latter.
10-23
Historically, German executives have not been dedicated to the maximization of shareholder
value. However, corporate governance in Germany is changing. Due at least partially to the
increasing globalization of business, many governance systems are beginning to gravitate
toward the US system.
Attitudes toward corporate governance in Japan are affected by the concepts of obligation,
family, and consensus. As part of a corporate family, individuals are members of a unit that
envelops their lives—even the keiretsu is a family, and certainly more than an economic
concept. Consensus, an important influence in Japanese corporate governance, calls for the
expenditure of significant amounts of energy to win the hearts and minds of people whenever
possible, as opposed to depending on edicts from top executives. Consensus is highly
valued, even when it results in a slow and cumbersome decision-making process.
As in Germany, banks play an important role in financing and monitoring large public firms
in Japan. The bank owning the largest share of stocks and the largest amount of debt (the
main bank) has the closest relationship with the company’s top executives. The main bank
provides financial advice to the firm and also closely monitors managers. Thus, Japan has a
bank-based financial and corporate governance structure compared to the United States’
market-based financial and governance structure.
Aside from lending money (debt), a Japanese bank can hold up to five percent of a firm’s
total stock; a group of related financial institutions can hold up to 40 percent. In many cases,
main-bank relationships are part of a horizontal keiretsu (a group of firms tied together by
cross-shareholdings). A keiretsu firm usually owns less than 2 percent of any other member
firm; however, each company typically has a stake of that size in every firm in the keiretsu.
As a result, somewhere between 30 percent and 90 percent of a typical firm is owned by
other members of the keiretsu. Thus, a keiretsu is a system of relationship investments.
As is the case in Germany, Japan’s corporate governance structure is changing. For example,
because of their continuing development as economic organizations, the role of banks in the
monitoring and control of managerial behavior and firm outcomes is less significant than it
has been. The Asian economic crisis in the later part of the 1990s substantially harmed
Japanese firms, making transparent the governance problems in the system.
Corporate governance in China has undergone major changes over the past decade, along
with the privatization of business and the development and integrity of the equity market.
Though these changes are significant, the state still dominates the strategies that most firms
employ. Research indicates that firms with higher state ownership have lower market value
and more volatility than those with less. This is because the state imposes social goals on
these firms and executives are not trying to maximize shareholder wealth.
Overall, the Chinese system of corporate governance has been moving toward a Western-
style model. Chinese executives are also being compensated based on firm financial
performance.
10-24
8. How can corporate governance foster ethical decisions and behaviors on the part
of managers as agents? (pp. 313–315)
In the United States, the focus of governance mechanisms is on the control of managerial
decisions to ensure that shareholders’ interests will be served, but product market
stakeholders (e.g., customers, suppliers, and host communities) and organizational
stakeholders (e.g., managerial and nonmanagerial employees) are important as well.
Therefore, at least the minimal interests or needs of all stakeholders must be satisfied by
outcomes from the firm’s actions. Otherwise, dissatisfied stakeholders will decide to
withdraw their support to one firm and provide it to another (e.g., customers will purchase
products from a supplier offering an acceptable substitute).
INSTRUCTOR'S NOTES FOR EXPERIENTIAL

—
EXERCISES
EXERCISE 1: Who Pays Better at the Top: Most- or Least-Admired Company?
The goal of this exercise is to have students evaluate differences between best and worst
(or at least how the Fortune ranking has them). The Fortune list seeks a wide range of
opinion from analysts, directors, and executives among others so it is thought that the
most admired seek the balance that the text discusses in the balanced scorecard.
Conversely the least admired are those firms that the same analysts and executives and
others find the least promising.
The full list may be found here

http://money.cnn.com/magazines/fortune/mostadmired/2011/full_list/. The instructor may
want to dictate the categories since there are nine, and that would enable each student
team to analyze firms from distinct categories. The best/worst list is found here:
http://money.cnn.com/magazines/fortune/mostadmired/2011/best_worst/best1.html.
The answer to how the lists are chosen may be found here:
http://money.cnn.com/magazines/fortune/mostadmired/2011/faq/.
All the answers to the questions 1 to 4 may be found at the firms 10K filing or annual
proxy report. Performance may be gathered through anyone of the financial websites
such as Yahoo Finance.
EXERCISE 2: Governance: Does It Matter Competitively?
For this exercise, students are asked to evaluate the governance of a firm they might
consider working for and then comparing that to the firms top competitor. The main
purpose of the exercise is to help make a connection between different governance
elements (e.g., board composition, equity holdings by directors, executive compensation)
10-25
and a firm’s financial performance. Students are asked to prepare a single page memo
and a graphical comparison of performance that addresses the following questions:
• Summarize what you consider the key aspects of the firm’s governance
mechanisms.
• Based on your review of the firm’s governance, did you change your opinion
of the firm’s desirability as an employer? Why or why not?
A secondary goal of the exercise is to familiarize students with proxy statements and 10K
filings as a resource for analyzing corporate governance. A related benefit is the use of
the Securities and Exchange Commission EDGAR database:
(http://www.sec.gov/edgar.shtml).
Because this exercise is completed individually, it can be helpful to spend some time in
class debriefing the assignment. An easy way to do this is to restate the question “Based
on your review of the firm’s governance, did you change your opinion of the firm’s
desirability as an employer?” Ask for a show of hands for those that did change their
opinion, and those that did not. Starting with the former group, ask:
• What prompted the change in opinion?
• Were there both positive and negative opinion changes?
• How strong was the change: relatively minor, moderate, or substantial?
Next, follow up with the “no change” group, and ask several students for the basis for
their assessment.
Finally, ask students how much weight they will play on corporate governance when
considering future decisions about that firm.
INSTRUCTOR'S NOTES FOR VIDEO EXERCISES
Title: KNOWLEDGE BRINGS CORPORATE GOVERNANCE:

WHISTLEBLOWING/STAFFORD GENERAL HOSPITAL
RT: 6:00
Topic Key: Corporate governance, Agency relationship, Market for corporate control,
International corporate governance, Global corporate governance
When hospital staff failed to speak out about poor care, the challenge began to fall on
relatives. Julie Bailey began to take on Stafford General Hospital. Believing that it would
never happen to her, it happened at Stafford where she took her mom. Julie Bailey’s
mother, Bella, had been taken to Stafford General Hospital in September 2007. But from
her first impression, she believed something was wrong. She recognized that the patients
in her mom’s ward couldn’t speak for themselves and the relatives visiting them were
oblivious to what was going on. For 8 weeks, Bella’s family members maintained a 24-
10-26
hour watch at her bedside, keeping a record of what they saw. Julie Bailey reads the
records they made that indicate the fear they had for being branded troublemakers. Bella
Bailey died in the hospital in November 2007. Julie Bailey created a determined
campaign in her café to make people aware of what she had seen but struggled make her
voice heard. In an interview, Julie listed all the people she tried to speak to with the intent
to try and tell as many people as possible.
At that time she was unaware that the primary investigator of the Health Care
Commission was planning to investigate high death rates at the hospital between 2005
and 2008. The report, when made public, showed managers putting targets ahead of
patient care. With the mortality rates being further investigated, the report agreed there
were serious concerns about patient care. It appeared that some doctors were even,
privately, aware of the problems. The Commission report also said that the majority of
doctors interviewed said they would not have been happy for a relative to have been
treated there. Julie Bailey expressed her concern that it wasn’t good enough for their
relatives but it was good enough for ours. She says if they had known or the doctors had
spoken out none of their relatives would have been put there. A Staffordshire MP, Tony
Wright—Labour, Cannock Chase, could not believe that doctors would be happy
delivering that level of care and that nurses must have been unhappy working in that
situation. He had helped introduce legislation to encourage employees to speak up. The
Public Interest Disclosure Act of 1998 was intended to give whistleblowers legal
protection from dismissal or victimization. Mr. Wright indicates that the whole point of
these provisions was so that individuals could raise their concerns properly without
threatening their job, without damaging their career, and without having to go to the
media. However, in Staffordshire, there was a whole culture that discouraged complaints.
The investigation indicated that nurses felt poorly supported as a profession and
consultants appeared to have given up expressing their views since managers were said to
dislike critical comments and ignored them. Mr. Wright says that the government should
revisit what it said to health organizations in the past—such as the need to get
whistleblower protection in place. The new leadership at Mid Staffordshire NHS
Foundation Trust has now made it known that quality of care is now its primary concern.
To this end, it is investing 12 million pounds in frontline clinical staff, improved training
and facilities, and has published a new “no blame whistleblowing policy” aimed to bring
poor practice out in the open.
Also check out http://news.bbc.co.uk/2/hi/uk_news/england/staffordshire/7948293.stm
Suggested Discussion Questions and Answers
• What corporate governance mechanisms failed at Stafford General Hospital?

o Text: 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 organizations.
o Stafford General Hospital Failures: (1) Ownership concentration—
Managers at the hospital were putting targets ahead of patient care. In
other words, there must have been some incorrect directive and incentive
given to managers to be more concerned about meeting the numbers rather
10-27
than with the patient care required by stakeholders. (2) With a hospital
culture that discouraged complaints and a new leadership after the report,
perhaps the oversight board of directors/leadership either instilled the
culture to managers or they failed to have appropriate oversight of
managers to ensure stakeholder satisfaction. (3) The last possible
governance failure may have been in executive compensation in that
Stafford leadership may have been compensated for the targets rather than
stakeholder return.
• Were there possibilities of agency problems within Stafford? Why or why not?
Could managerial opportunism be an issue?
o Text: Agency relationship exists when one or more person (the principal
or principals) hire another person or persons (the agent or agents) as
decision-making specialists to perform a service.
o Agency Problems at Stafford: Absolutely. It is very possible that overall
leadership hired managers who had different interest and goals. Thus,
managers pursued targets ahead of patient care. Also, due to expanded
services of the hospital, managers could have become overloaded in
responsibility and resorted to what was most important—managing the
numbers.
o Text: Managerial Opportunism is the seeking of self-interest with guile.
o Stafford Managerial Opportunism: Stafford managers may have seen ways
to earn extra compensation incentives by being more concerned for targets
than patient care.
• Can the Trust Foundation for Stafford be effective as a market for corporate
control?
o Text: The market for corporate control is an external governance
mechanism that becomes active when a firm’s internal controls fail.
o Trust Foundation: The Trust Foundation, while its intent may not be to
diversify or merge hospitals, has taken over a very undervalued hospital to
form one that takes necessary steps to improve patient care. Can it be
effective? It must be. Investing 12 million pounds in frontline clinical
staff, improved training and facilities and publishing a new “no blame
whistleblowing policy” aimed to bring poor practice out in the open are
appropriate steps in corporate control.
• What role do you think the corporate governance structure of the United Kingdom
played in the problems at Stafford?
o Text: Effective corporate governance is also of interest to nations.
Although corporate governance reflects company standards, it also
collectively reflects country societal standards
o United Kingdom: In the United Kingdom, the fundamental goal of
business organizations is to maximize shareholder value. Therefore, this
mentality became prevalent at Stafford and agents and principals operated
the hospital in that manner.
• How do you think the situation at Stafford will impact global corporate
governance?
o As countries and companies seek to attract foreign investments and
10-28
awareness of global happenings become much quicker, the situation at

Stafford can easily detract interest in foreign investment in United
Kingdom hospital facilities, pronounce lack of global confidence in United
Kingdom hospital facilities, and raise the global bar in hospital care and
corporate governance due to concerns of repeating the Stafford situation
across the world.
— ADDITIONAL QUESTIONS AND EXERCISES
The following questions and exercises can be presented for in-class discussion or assigned as
homework.
Application Discussion Questions
1. The roles and responsibilities of top executives and members of a corporation’s board of
directors are different. Traditionally, executives have been responsible for determining
the firm’s strategic direction and implementing strategies to achieve it, whereas the board
of directors has been responsible for monitoring and controlling managerial decisions and
actions. Some argue that boards should become more involved with the formulation of a
firm’s strategies. How would the board’s increased involvement in the selection of
strategies affect a firm’s strategic competitiveness? What evidence can the students offer
to support their position?
2. Ask students if they believe that large US firms have been overgoverned by some
corporate governance mechanisms and undergoverned by others. Provide an example of
each.
3. How can corporate governance mechanisms create conditions that allow top executives to
develop a competitive advantage and focus on long-term performance? Have students use
the Internet to search the business press and give an example of a firm in which this
occurred.
4. Some believe that the market for corporate control is not an effective governance
mechanism. What factors might account for the ineffectiveness of this method of
monitoring and controlling managerial decisions?
5. Present the following comment to the class: “As a top executive, the only agency
relationship I am concerned about is the one between myself and the firm’s owners. I
think that it would be a waste of my time and energy to worry about any other agency
relationships.” What are these other agency relationships? How would students respond
to this person? Do they accept or reject this view? Have them support their position.
Ethics Questions
1. As explained in this chapter, using corporate governance mechanisms should establish

order between parties whose interests may be in conflict. Do owners of a firm have any
ethical responsibilities to managers in a firm that uses governance mechanisms to
establish order? If so, what are those responsibilities?
10-29
2. Is it ethical for a firm’s owner to assume that agents (managers hired to make decisions in
the owner’s best interests) are averse to risk? Why or why not?
3. What are the responsibilities of the board of directors to stakeholders other than
shareholders?
4. What ethical issues surround executive compensation? How can we determine whether
top executives are paid too much?
5. Is it ethical for firms involved in the market for corporate control to target companies
performing at levels exceeding the industry average? Why or why not?
6. What ethical issues, if any, do top executives face when asking their firm to provide them
with a golden parachute?
7. How can governance mechanisms be designed to ensure against managerial opportunism,
ineffectiveness, and unethical behaviors?
Internet Exercise
The use of the Internet for buying and selling stocks has opened up markets to an
unprecedented number of people. With the click of a mouse, one can buy shares of the hottest
stocks. Not always so, though, warns the chairman of the SEC. Orders are not necessarily
processed at the moment they are sent, and by the time the stock is purchased, the price may
have risen ten-fold. Read more about investing through the Internet and the SEC’s efforts to
combat growing Internet-based investment fraud at http://www.sec.gov.
*e-project: Visit two online trading venues: the more traditional Merrill Lynch at
www.merrill-lynch.com and the newer E*Trade at www.etrade.com. How well do these
companies communicate the risks of a volatile market to their customers? Looking at the
SEC’s recommendations, how does each company rate?
10-30

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Chapter 10: Corporate Governance

Opening Case Corporate Governance: What Is All the Fuss About?

GOVERNANCE MECHANISMS AND ETHICAL BEHAVIOR

Chapter Introduction: The purpose of this chapter is to present and discuss

governance issues/governance breakdowns and to speculate about why the

Define corporate governance and explain why it is used to

Effective corporate governance is also of interest to nations. Governments want firms

Teaching Note: In the chapter, corporate governance is discussed from two

Explain why ownership is largely separated from

SEPARATION OF OWNERSHIP AND MANAGERIAL CONTROL

Shareholders make investments by purchasing stock (representing ownership), which entitles

Define an agency relationship and managerial opportunism

Note the following in the figure (Figure 10.1):

An agency relationship enables the possibility of managerial opportunism, the seeking of

Product Diversification as an Example of an Agency Problem

Product diversification—discussed in Chapter 6—can be beneficial to both shareholders and

Agency Costs and Governance Mechanisms

Explain the use of three internal governance mechanisms to

The Increasing Influence of Institutional Owners

Institutional owners are large-block shareholder positions controlled by financial

Table Note: Table 10.1 provides characteristics of three classifications of

Teaching Note: Outside directors (and boards) are perceived as ineffective

The drawbacks of outside boards:

Enhancing the Effectiveness of the Board of Directors

Many boards have voluntarily initiated changes, including:

Teaching Note: McKinsey & Co. research found that institutional

Research shows that boards working collaboratively with management:

Discuss the types of compensation executives receive and

Executive compensation is a governance mechanism that seeks to align managers’ and

Using executive compensation as a governance mechanism is more challenging in

Teaching Note: When DaimlerBenz acquired Chrysler, it highlighted the fact

Developing and implementing an effective incentive compensation program is quite

Although long-term performance-based incentives may reduce temptations to under-invest in

The Effectiveness of Executive Compensation

The compensation received by top-level managers, especially by CEOs, is often a subject of

Repricing stock options does not appear to be a function of management entrenchment or

Teaching Note: Board directors also receive compensation. Some recent

Describe how the external corporate governance mechanism—

MARKET FOR CORPORATE CONTROL

A Brief History of the Market for Corporate Control

Managerial Defense Tactics

Teaching Note: As mentioned throughout the chapter, internal and external

Discuss the nature and use of corporate governance in

INTERNATIONAL CORPORATE GOVERNANCE

Our discussion of internal and external governance mechanisms—and their effectiveness in

Corporate Governance in Germany and Japan

Banks historically have occupied a central position in German governance structure.

Corporate governance in Japan is affected by the concepts of obligation, family, and

Corporate Governance in China

Teaching Note: Examples of differences and changes in international

Describe how corporate governance fosters the making of

GOVERNANCE MECHANISMS AND ETHICAL BEHAVIOR

— ANSWERS TO REVIEW QUESTIONS

1. What is corporate governance? What factors account for the considerable

Corporate governance is a relationship among stakeholders that is used to determine and

Corporate governance receives a great deal of attention because governance mechanisms

As owners delegate strategy development and decision making to managers, conflicts of

2. What is meant by the statement that ownership is separated from managerial

3. What is an agency relationship? What is managerial opportunism? What

4. How is each of the three internal governance mechanisms—ownership

Ownership concentration is an effective governance mechanism because owners of large

Monitoring and controlling managerial decisions are supposed to be accomplished through

immediate, making it difficult to assess the effect of decisions on the corporation’s

Increasingly, long-term incentive plans are becoming a critical part of compensation