10

Creating Effective
Organizational Designs

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Learning Objectives

  • After reading this chapter, you should have a good understanding of:
  • The importance of organizational structure and the concept of the “boundaryless” organization in implementing strategies.
  • The growth patterns of major corporations and the relationship between a firm’s strategy and its structure.
  • Each of the traditional types of organizational structure: simple, functional, divisional, and matrix
  • The relative advantages and disadvantages of traditional organizational structure
  • The implications of a firm’s international operations for organizational structure

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Learning Objectives

  • After reading this chapter, you should have a good understanding of:
  • Why there is no “one best way” to design strategic reward and evaluation systems, and the important contingent roles of business- and corporate-level strategies.
  • The different types of boundaryless organizations—barrier-free, modular, and virtual—and their relative advantages and disadvantages
  • The need for creating ambidextrous organizational designs that enable firms to explore new opportunities and effectively integrate existing operations

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Traditional Forms of
Organizational Structure

  • Organizational structure refers to formalized patterns of interactions that link a firm’s
  • Tasks
  • Technologies
  • People
  • Structure provides a means of balancing two conflicting forces
  • Need for the division of tasks into meaningful groupings
  • Need to integrate the groupings for efficiency and effectiveness

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Question

Most organizations begin very small and ______.

A) grow to become a medium sized organization

B) continually grow

C) remain small

D) often decrease in size

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Answer: C

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Dominant Growth Patterns
of Large Corporations

Adapted from Exhibit 10.1 Dominant Growth Patterns of Large Corporations

Source: Adapted from J. R. Galbraith and R. K. Kazanjian, Strategy Implementation: The Role of Structure and Process, 2nd ed. (St. Paul, MN: West Publishing Company, 1986), p. 139.

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Patterns of Growth of
Large Corporations

  • Simple Structure
  • Simple structure is the oldest and most common organizational form
  • Staff serve as an extension of the top executive’s personality
  • Highly informal
  • Coordination of tasks by direct supervision
  • Decision making is highly centralized
  • Little specialization of tasks, few rules and regulations, informal evaluation and reward system

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Patterns of Growth of
Large Corporations

  • Functional Structure

Adapted from Exhibit 10.2 Functional Organizational Structure

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Patterns of Growth
of Large Corporations

  • Functional Structure
  • Found where there is a single or closely related product or service, high production volume, and some vertical integration
  • Advantages
  • Enhanced coordination and control
  • Centralized decision making
  • Enhanced organizational-level perspective
  • More efficient use of managerial and technical talent
  • Facilitated career paths and development in specialized areas

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Patterns of Growth
of Large Corporations

  • Disadvantages
  • Impeded communication and coordination due to differences in values and orientations
  • May lead to short-term thinking (functions vs. organization as a whole)
  • Difficult to establish uniform performance standards

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Divisional Structure

Adapted from Exhibit 10.3 Divisional Organizational Structure

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Divisional Structure

  • Organized around products, projects, or markets
  • Each division includes its own functional specialists typically organized into departments
  • Divisions are relatively autonomous and consist of products and services that are different from those of other divisions
  • Division executives help determine product-market and financial objectives

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Divisional Structure

  • Advantages
  • Strategic business unit (SBU) structure
  • Separation of strategic and operating control
  • Quick response to important changes in external environment
  • Minimal problems of sharing resources across functional departments
  • Development of general management talent is enhanced

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Divisional Structure

  • Disadvantages
  • Can be very expensive
  • Can be dysfunctional competition among divisions
  • Can be a sense of a “zero-sum” game that discourages sharing ideas and resources among divisions
  • Differences in image and quality may occur across divisions
  • Can focus on short-term performance

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Divisional Structure

  • Strategic business unit (SBU) structure
  • Divisions with similar products, markets, and/or technologies are grouped into homogenous SBUs
  • Task of planning and control at corporate office is more manageable
  • May become difficult to achieve synergies across SBUs
  • Appropriate when the businesses in a corporation’s portfolio do not have much in common
  • Lower expenses and overhead, fewer levels in the hierarchy
  • Inherent lack of control and dependence of CEO-level executives on divisional executives

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Matrix Structure

Adapted from Exhibit 10.4 Matrix Organizational Structure

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Matrix Structure

  • A combination of the functional and divisional structures
  • Individuals who work in a matrix organization become responsible to two managers
  • The project manager
  • The functional area manager

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Matrix Structure

  • Advantages
  • Facilitates the use of specialized personnel, equipment and facilities
  • Provides professionals with a broader range of responsibility and experience
  • Disadvantages
  • Can cause uncertainty and lead to intense power struggles
  • Working relationships become more complicated
  • Decisions may take longer

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International Operations: Implications for Organizational Structure

  • Three major contingencies influence structure adopted by firms with international operations
  • Type of strategy driving the firm’s foreign operations
  • Product diversity
  • Extent to which the firm is dependent on foreign sales
  • Structures used to manage international operations
  • International division
  • Geographic-area division
  • Worldwide functional
  • Worldwide product division
  • Worldwide matrix

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Example

  • Nike culture used to encourage local managers to focus on market share rather than profitability.
  • This lead to Wall Street to comment on the lack of managerial control at Nike.
  • Nike decided to implement a matrix structure to resolve this issue.
  • This matrix structure clearly stated local managers’ responsibilities by region and product.
  • Nike headquarters establishes which products to focus on and how to do it under the new matrix structure.

Source: “The New Nike,” Business Week. September 20, 2004

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Question

Does the relationship between strategy and structure imply that structure follows strategy?

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The strategy of a firm influences their structural elements as the division of tasks. It is also true that existing structures can influence the formulation of strategies of a firm. Ultimately, strategy cannot be developed without the consideration of a firm’s structural elements.

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Relationships between Rewards & Evaluation Systems and Business-level and Corporate-level Strategies

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Boundaryless Organizational Designs

  • Boundaries that place limits on organizations
  • Vertical boundaries between levels in the organization’s hierarchy
  • Horizontal boundaries between functional areas
  • External boundaries between the firm and its customers, suppliers, and regulators
  • Geographic boundaries between locations, cultures and markets

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Making Boundaries More Permeable

  • First approach
  • Permeable internal boundaries
  • Higher level of trust and shared interests
  • Shift in philosophy from executive development of organizational development
  • Greater use of teams
  • Flexible, porous organizational boundaries
  • Communication flows and mutually beneficial relationships with internal and external constituencies

Barrier-free type of organization

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Pros and Cons of
Barrier-Free Structures

Adapted from Exhibit 10.7 Pros and Cons of Barrier-Free Structures

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Making Boundaries More Permeable

  • Second approach
  • Outsources nonvital functions, tapping

into knowledge and expertise of “best in class” suppliers but retains strategic control

  • Three advantages
  • Decrease overall costs, leverage capital
  • Enables company to focus scarce resources on areas where it holds competitive advantage
  • Adds critical skills and accelerates organizational learning

Modular type of organization

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Pros and Cons of Modular Structures

Adapted from Exhibit 10.8 Pros and Cons of Modular Structures

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Making Boundaries More Permeable

  • Third approach
  • Continually evolving network of

independent companies linked together to share skills, costs, and access to one another’s markets

  • Suppliers
  • Customers
  • Competitors
  • Each gains from resulting individual and organizational learning
  • May not be permanent

Virtual type of organization

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Pros and Cons of Virtual Structures

Source: R. E. Miles and C. C. Snow, “Organizations: New Concepts for New Forms,” California Management Review,” Spring 1986, pp. 62-73; R. E. Miles and C. C. Snow, “Causes of Failure in Network Organizations,” California Management Review, Summer 1999, pp. 53-72; and H. Bahrami, “The Emerging Flexible Organization: Perspectives from Silicon Valley,” California Management Review, Summer 1991, pp. 33-52.

Adapted from Exhibit 10.9 Pros and Cons of Virtual Structures

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Boundaryless Organizations:
Making Them Work

  • Factors facilitating effective coordination and integration of key activities
  • Common culture and shared values
  • Horizontal organization structures
  • Horizontal systems and processes
  • Communications and information technologies
  • Human resource practices

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Creating Ambidextrous
Organizational Designs

  • Two contradictory challenges faced by firms
  • Adaptability
  • Alignment
  • Ambidextrous organizations
  • Aligned and efficient in how they manage in today’s business
  • Flexible enough to changes in the environment so they will prosper tomorrow

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Creating Effective
Organizational Designs

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chapter 9

Strategic Control and Corporate Governance

After reading this chapter, you should have a good understanding of the following learning objectives:

LO9.1   The value of effective strategic control systems in strategy implementation.

LO9.2   The key difference between “traditional” and “contemporary” control systems.

LO9.3   The imperative for “contemporary” control systems in today’s complex and rapidly changing competitive and general environments.

LO9.4   The benefits of having the proper balance among the three levers of behavioral control: culture, rewards and incentives, and boundaries.

LO9.5   The three key participants in corporate governance: shareholders, management (led by the CEO), and the board of directors.

LO9.6   The role of corporate governance mechanisms in ensuring that the interests of managers are aligned with those of shareholders from both the United States and international perspectives.

Learning from Mistakes

Hewlett-Packard (HP) is one of the largest firms in the world and also one of the most dysfunctional. Sitting #10 on the Fortune 500 list with $120 billion in sales in 2012, it is a titan in the computer hardware market.1 However, it is a struggling titan that lost $12.6 billion in 2012, in contrast to earnings of almost $9 billion only two years earlier. But HP’s struggles go back much farther than the last two years. Their inability to effectively respond to the dramatic shifts that have transformed the computing industry in the last several years has been, at least partly, driven by their toxic corporate governance culture.

The dynamics in the board of directors has resembled a soap opera for over 10 years. Going back to 2002, HP’s CEO, Carly Fiorina, was pushing hard for HP to acquire one of its main rivals, Compaq. Standing in her way to get this deal done was Walter Hewitt, the son of one of the firm’s founders. The members of the board took sides in this debate and started leaking corporate secrets to the press to bolster their side of the argument. HP eventually did acquire Compaq, but the toxic culture in the boardroom was set.

Fiorina stayed at the helm of HP until early 2005, when she was forced out by the board—but only after board

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members leaked documents damaging to Fiorina in the press. She was replaced by Mark Hurd, but the troubles with the board continued. The chairwoman of the board was accused in 2006 of hiring private investigators to obtain the phone records of board members and reporters to try to get at the root of leaks from the board. The scandal was investigated by both the State of California and the U.S. Congress and resulted in Patricia Dunn, the chairwoman, being forced from her position. Hurd, the firm’s CEO, was fired in 2010 when it came to light that he had an inappropriate affair with a subordinate and had charged expenses related to his affair to the firm. His departure only served to exacerbate the tension on the board. He had been dismissed on a 6-4 vote by the board, and the tension between the pro- and anti-Hurd factions on the board spilled over to the search for his replacement. It got so bad that some board members refused to be in the same room with other directors. The board settled on Leo Apotheker to replace Hurd, but only after the search firm vetting Apotheker didn’t fully disclose issues related to Apotheker that led to his firing from his position of co-CEO at SAP, an enterprise software firm. Apotheker lasted all of 11 months as CEO at HP before he was fired, receiving a $13.2 million dollar severance package from the board. He was replaced by Meg Whitman, the former CEO of eBay, in 2011.

All of the drama in the boardroom has had a devastating effect on HP’s businesses. The strategic direction of the firm has been inconsistent over time, moving from traditional hardware, to mobile devices, to computing services, and finally to cloud computing. HP announced it was planning to spin off its PC business only to quickly move away from that plan once the market reacted to the announcement by pummeling the firm’s stock. The drama also infested the rest of the company. Both Apotheker and Whitman have had to deal with employees leaking important and damaging information to the press, much like the board has done for years. As a result, there has been very little information sharing within the organization, because no one knows who they can trust and who will leak important information to the press.

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Discussion Questions

1.   What are the most significant problems with HP’s board?

2.   How do we see the problems with the board of directors damaging HP’s ability to compete in its markets?

We first explore two central aspects of strategic control :2 (1) informational control, which is the ability to respond effectively to environmental change, and (2) behavioral control, which is the appropriate balance and alignment among a firm’s culture, rewards, and boundaries. In the final section of this chapter, we focus on strategic control from a much broader perspective—what is referred to as corporate governance. 3 Here, we direct our attention to the need for a firm’s shareholders (the owners) and their elected representatives (the board of directors) to ensure that the firm’s executives (the management team) strive to fulfill their fiduciary duty of maximizing long-term shareholder value. As we just saw in the HP example, poor corporate governance can result in significant loss of managerial attention and of the ability to manage major strategic issues.

strategic control

the process of monitoring and correcting a firm’s strategy and performance.

LO9.1

The value of effective strategic control systems in strategy implementation.

Ensuring Informational Control: Responding Effectively to Environmental Change

We discuss two broad types of control systems: “traditional” and “contemporary.” As both general and competitive environments become more unpredictable and complex, the need for contemporary systems increases.

A Traditional Approach to Strategic Control

The traditional approach to strategic control is sequential: (1) strategies are formulated and top management sets goals, (2) strategies are implemented, and (3) performance is measured against the predetermined goal set, as illustrated in Exhibit 9.1.

traditional approach to strategic control

a sequential method of organizational control in which (1) strategies are formulated and top management sets goals, (2) strategies are implemented, and (3) performance is measured against the predetermined goal set.

Control is based on a feedback loop from performance measurement to strategy formulation. This process typically involves lengthy time lags, often tied to a firm’s annual planning cycle. Such traditional control systems, termed “single-loop” learning by Harvard’s Chris Argyris, simply compare actual performance to a predetermined goal.4 They are most appropriate when the environment is stable and relatively simple, goals and objectives can be measured with a high level of certainty, and there is little need for complex measures of performance. Sales quotas, operating budgets, production schedules, and similar quantitative control mechanisms are typical. The appropriateness of the business strategy or standards of performance is seldom questioned.5

James Brian Quinn of Dartmouth College has argued that grand designs with precise and carefully integrated plans seldom work.6 Rather, most strategic change proceeds incrementally—one step at a time. Leaders should introduce some sense of direction, some logic in incremental steps.7 Similarly, McGill University’s Henry Mintzberg has written about leaders “crafting” a strategy.8 Drawing on the parallel between the potter at her wheel and the strategist, Mintzberg pointed out that the potter begins work with some general idea of the artifact she wishes to create, but the details of design—even possibilities for a different design—emerge as the work progresses. For businesses facing complex and turbulent business environments, the craftsperson’s method helps us deal with the uncertainty about how a design will work out in practice and allows for a creative element.

LO9.2

The key difference between “traditional” and “contemporary” control systems.

EXHIBIT 9.1   Traditional Approach to Strategic Control

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Mintzberg’s argument, like Quinn’s, questions the value of rigid planning and goal-setting processes. Fixed strategic goals also become dysfunctional for firms competing in highly unpredictable competitive environments. Strategies need to change frequently and opportunistically. An inflexible commitment to predetermined goals and milestones can prevent the very adaptability that is required of a good strategy.

LO9.3

The imperative for “contemporary” control systems in today’s complex and rapidly changing competitive and general environments.

A Contemporary Approach to Strategic Control

Adapting to and anticipating both internal and external environmental change is an integral part of strategic control. The relationships between strategy formulation, implementation, and control are highly interactive, as suggested by Exhibit 9.2. It also illustrates two different types of strategic control: informational control and behavioral control. Informational control is primarily concerned with whether or not the organization is “doing the right things.” Behavioral control, on the other hand, asks if the organization is “doing things right” in the implementation of its strategy. Both the informational and behavioral components of strategic control are necessary, but not sufficient, conditions for success. What good is a well-conceived strategy that cannot be implemented? Or what use is an energetic and committed workforce if it is focused on the wrong strategic target?

informational control

a method of organizational control in which a firm gathers and analyzes information from the internal and external environment in order to obtain the best fit between the organization’s goals and strategies and the strategic environment.

behavioral control

a method of organizational control in which a firm influences the actions of employees through culture, rewards, and boundaries.

John Weston is the former CEO of ADP Corporation, the largest payroll and tax-filing processor in the world. He captures the essence of contemporary control systems.

At ADP, 39 plus 1 adds up to more than 40 plus 0. The 40-plus-0 employee is the harried worker who at 40 hours a week just tries to keep up with what’s in the “in” basket…. Because he works with his head down, he takes zero hours to think about what he’s doing, why he’s doing it, and how he’s doing it…. On the other hand, the 39-plus-1 employee takes at least 1 of those 40 hours to think about what he’s doing and why he’s doing it. That’s why the other 39 hours are far more productive.9

Informational control deals with the internal environment as well as the external strategic context. It addresses the assumptions and premises that provide the foundation for an organization’s strategy. Do the organization’s goals and strategies still “fit” within the context of the current strategic environment? Depending on the type of business, such assumptions may relate to changes in technology, customer tastes, government regulation, and industry competition.

This involves two key issues. First, managers must scan and monitor the external environment, as we discussed in Chapter 2. Also, conditions can change in the internal environment of the firm, as we discussed in Chapter 3, requiring changes in the strategic direction of the firm. These may include, for example, the resignation of key executives or delays in the completion of major production facilities.

In the contemporary approach, information control is part of an ongoing process of organizational learning that continuously updates and challenges the assumptions that underlie the organization’s strategy. In such “double-loop” learning, the organization’s assumptions, premises, goals, and strategies are continuously monitored, tested, and reviewed. The benefits of continuous monitoring are evident—time lags are dramatically shortened,

EXHIBIT 9.2   Contemporary Approach to Strategic Control

280

changes in the competitive environment are detected earlier, and the organization’s ability to respond with speed and flexibility is enhanced.

STRATEGY SPOTLIGHT

9.1

HOW DO MANAGERS AND EMPLOYEES VIEW THEIR FIRM’S CONTROL SYSTEM?

Top executives of organizations often assert that they are pushing for more contemporary control systems. The centralized, periodic setting of objectives and rules with top-down implementation processes is ineffective for organizations facing heterogeneous and dynamic environments. For example, Walmart has, in recent years, realized its top-down, rule-based leadership system was too rigid for a firm emphasizing globalization and technological change. Like many other firms, Walmart is moving to a more decentralized, values-based leadership system where lower-level managers make key decisions, keeping the values of the firm in mind as they do so.

Managers of firms see the need to make this transition, but do lower-level managers and workers see a change in the control systems at their organizations? To get at this question, the Boston Research Group conducted a study of 36,000 managers and employees to get their views on their firm’s control systems. Their findings are enlightening. Only 3 percent of employees saw their firm’s culture as “self-governing,” in which decision making is driven by a “set of core principles and values.” In contrast, 43 percent of employees saw their firm as operating using a top-down, command-and-control decision process, what the authors of the study labeled as the “blind obedience” model. 53 percent of employees saw their firm following an “informed acquiescence” model where the overall style is top-down but with skilled management that used a mix of rewards and rules to get the desired behavior. In total, 97 percent of employees saw their firm’s culture and decision style as being top-down.

Interestingly, managers had a different view. 24 percent of managers believed their organizations used the values-driven, decentralized “self-governing” model. Thus, managers were eight times more likely than employees to see the firm employing a contemporary, values-driven control system. Similarly, while 41 percent of managers said that their firm rewarded performance based on values and not just financial outcomes, only 14 percent of employees saw this.

The cynicism employees expressed regarding the control systems in their firms had important consequences for the firm. Almost half of the employees who had described their firms as “blind obedience” firms had witnessed unethical behavior in the firm within the last year. Only one in four employees in firms with the other two control types said they had witnessed unethical behavior. Additionally, only one-fourth of the employees in “blind obedience” firms would blow the whistle on unethical behavior, but this rate went up to nine in ten if the firm relied on “self-governance.” Finally, the impressions of employees influence the ability of the firm to be responsive and innovative. 90 percent of employees in “self-governing” and 67 percent of employees in “informed acquiescence” firms agreed with the statement that “good ideas are readily adopted by my company.” Less than 20 percent of employees in “blind obedience” firms agreed with the same statement.

These findings indicate that managers need to be aware of how the actions they take to improve the control systems in their firms are being received by employees. If the employees see the pronouncements of management regarding moving toward a decentralized, culture-centered control system as simply propaganda, the firm is unlikely to experience the positive changes they desire.

Sources: Anonymous. 2011. The view from the top and bottom. Economist, September 24: 76; and Levit, A. 2012. Your employees aren’t wearing your rose colored glasses. Openforum.com , November 12: np.

Contemporary control systems must have four characteristics to be effective.10

1.   Focus on constantly changing information that has potential strategic importance.

2.   The information is important enough to demand frequent and regular attention from all levels of the organization.

3.   The data and information generated are best interpreted and discussed in face-to-face meetings.

4.   The control system is a key catalyst for an ongoing debate about underlying data, assumptions, and action plans.

An executive’s decision to use the control system interactively—in other words, to invest the time and attention to review and evaluate new information—sends a clear signal to the organization about what is important. The dialogue and debate that emerge from such an interactive process can often lead to new strategies and innovations. Strategy Spotlight 9.1 discusses how managers and employees each see the control systems at work in their companies and some of the consequences of those impressions.

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LO9.4

The benefits of having the proper balance among the three levers of behavioral control: culture, rewards and incentives, and boundaries.

Attaining Behavioral Control: Balancing Culture, Rewards, and Boundaries

Behavioral control is focused on implementation—doing things right. Effectively implementing strategy requires manipulating three key control “levers”: culture, rewards, and boundaries (see Exhibit 9.3). There are two compelling reasons for an increased emphasis on culture and rewards in a system of behavioral controls.11

First, the competitive environment is increasingly complex and unpredictable, demanding both flexibility and quick response to its challenges. As firms simultaneously downsize and face the need for increased coordination across organizational boundaries, a control system based primarily on rigid strategies, rules, and regulations is dysfunctional. The use of rewards and culture to align individual and organizational goals becomes increasingly important.

Second, the implicit long-term contract between the organization and its key employees has been eroded.12 Today’s younger managers have been conditioned to see themselves as “free agents” and view a career as a series of opportunistic challenges. As managers are advised to “specialize, market yourself, and have work, if not a job,” the importance of culture and rewards in building organizational loyalty claims greater importance.

Each of the three levers—culture, rewards, and boundaries—must work in a balanced and consistent manner. Let’s consider the role of each.

Building a Strong and Effective Culture

Organizational culture is a system of shared values (what is important) and beliefs (how things work) that shape a company’s people, organizational structures, and control systems to produce behavioral norms (the way we do things around here).13 How important is culture? Very. Over the years, numerous best sellers, such as Theory Z, Corporate Cultures, In Search of Excellence, and Good to Great, 14 , have emphasized the powerful influence of culture on what goes on within organizations and how they perform.

organizational culture

a system of shared values and beliefs that shape a company’s people, organizational structures, and control systems to produce behavioral norms.

Collins and Porras argued in Built to Last that the key factor in sustained exceptional performance is a cultlike culture.15 You can’t touch it or write it down, but it’s there in every organization; its influence is pervasive; it can work for you or against you.16 Effective leaders understand its importance and strive to shape and use it as one of their important levers of strategic control.17

EXHIBIT 9.3   Essential Elements of Behavioral Control

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The Role of Culture Culture wears many different hats, each woven from the fabric of those values that sustain the organization’s primary source of competitive advantage. Some examples are:

•   FedEx and Amazon focus on customer service.

•   Lexus (a division of Toyota) and Apple emphasize product quality.

•   Google and 3M place a high value on innovation.

•   Nucor (steel) and Walmart are concerned, above all, with operational efficiency.

Culture sets implicit boundaries—unwritten standards of acceptable behavior—in dress, ethical matters, and the way an organization conducts its business.18 By creating a framework of shared values, culture encourages individual identification with the organization and its objectives. Culture acts as a means of reducing monitoring costs.19

Strong culture can lead to greater employee engagement and provide a common purpose and identity. Firms have typically relied on economic incentives for workers, using a combination of rewards (carrots) and rules and threats (sticks) to get employees to act in desired ways. But these systems rely on the assumption that individuals are fundamentally self-interested and selfish. However, research suggests that this assumption is overstated.20 When given a chance to act selfishly or cooperatively with others, over half choose to cooperate, while only 30 percent consistently choose to act selfishly. Thus, cultural systems that build engagement, communication, and a sense of common purpose and identity would allow firms to leverage these collaborative workers.

Sustaining an Effective Culture Powerful organizational cultures just don’t happen overnight, and they don’t remain in place without a strong commitment—both in terms of words and deeds—by leaders throughout the organization.21 A viable and productive organizational culture can be strengthened and sustained. However, it cannot be “built” or “assembled”; instead, it must be cultivated, encouraged, and “fertilized.”22

Storytelling is one way effective cultures are maintained. Many are familiar with the story of how Art Fry’s failure to develop a strong adhesive led to 3M’s enormously successful Post-it Notes. Perhaps less familiar is the story of Francis G. Okie.23 In 1922 Okie came up with the idea of selling sandpaper to men as a replacement for razor blades. The idea obviously didn’t pan out, but Okie was allowed to remain at 3M. Interestingly, the technology developed by Okie led 3M to develop its first blockbuster product: a waterproof sandpaper that became a staple of the automobile industry. Such stories foster the importance of risk taking, experimentation, freedom to fail, and innovation—all vital elements of 3M’s culture.

Rallies or “pep talks” by top executives also serve to reinforce a firm’s culture. The late Sam Walton was known for his pep rallies at local Walmart stores. Four times a year, the founders of Home Depot—former CEO Bernard Marcus and Arthur Blank—used to don orange aprons and stage Breakfast with Bernie and Arthur, a 6:30 a.m. pep rally, broadcast live over the firm’s closed-circuit TV network to most of its 45,000 employees.24

Southwest Airlines’ “Culture Committee” is a unique vehicle designed to perpetuate the company’s highly successful culture. The following excerpt from an internal company publication describes its objectives:

The goal of the Committee is simple—to ensure that our unique Corporate Culture stays alive…. Culture Committee members represent all regions and departments across our system and they are selected based upon their exemplary display of the “Positively Outrageous Service” that won us the first-ever Triple Crown; their continual exhibition of the “Southwest Spirit” to our Customers and to their fellow workers; and their high energy level, boundless enthusiasm, unique creativity, and constant demonstration of teamwork and love for their fellow workers.25

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Motivating with Rewards and Incentives

Reward and incentive systems represent a powerful means of influencing an organization’s culture, focusing efforts on high-priority tasks, and motivating individual and collective task performance.26 Just as culture deals with influencing beliefs, behaviors, and attitudes of people within an organization, the reward system —by specifying who gets rewarded and why—is an effective motivator and control mechanism.27 The managers at Not Your Average Joe’s, a Massachusett’s-based restaurant chain, changed their staffing procedures both to let their servers better understand their performance and to better motivate them.28 The chain uses sophisticated software to track server performance—both in per customer sales and customer satisfaction as seen in tips. Highly rated servers are given more tables and preferred schedules. In shifting more work and better schedules to the best workers, the chain hopes to improve profitability and motivate all workers.

reward system

policies that specify who gets rewarded and why.

The Potential Downside While they can be powerful motivators, reward and incentive policies can also result in undesirable outcomes in organizations. At the individual level, incentives can go wrong for multiple reasons. First, if individual workers don’t see how their actions relate to how they are compensated, they can be demotivating. For example, if the rewards are related to the firm’s stock price, workers may feel that their efforts have little if any impact and won’t perceive any benefit from working harder. On the other hand, if the incentives are so closely tied to their individual work, they may lead to dysfunctional outcomes. For example, if a sales representative is rewarded for sales volume, she will be incentivized to sell at all costs. This may lead her to accept unprofitable sales or push sales through distribution channels the firm would rather avoid. Thus, the collective sum of individual behaviors of an organization’s employees does not always result in what is best for the organization; individual rationality is no guarantee of organizational rationality.

Reward and incentive systems can also cause problems across organizational units. As corporations grow and evolve, they often develop different business units with multiple reward systems. They may differ based on industry contexts, business situations, stage of product life cycles, and so on. Subcultures within organizations may reflect differences among functional areas, products, services, and divisions. To the extent that reward systems reinforce such behavioral norms, attitudes, and belief systems, cohesiveness is reduced; important information is hoarded rather than shared, individuals begin working at cross-purposes, and they lose sight of overall goals.

Such conflicts are commonplace in many organizations. For example, sales and marketing personnel promise unrealistically quick delivery times to bring in business, much to the dismay of operations and logistics; overengineering by R&D creates headaches for manufacturing; and so on. Conflicts also arise across divisions when divisional profits become a key compensation criterion. As ill will and anger escalate, personal relationships and performance may suffer.

Creating Effective Reward and Incentive Programs To be effective, incentive and reward systems need to reinforce basic core values, enhance cohesion and commitment to goals and objectives, and meet with the organization’s overall mission and purpose.29

At General Mills, to ensure a manager’s interest in the overall performance of his or her unit, half of a manager’s annual bonus is linked to business-unit results and half to individual performance.30 For example, if a manager simply matches a rival manufacturer’s performance, his or her salary is roughly 5 percent lower. However, if a manager’s product ranks in the industry’s top 10 percent in earnings growth and return on capital, the manager’s total pay can rise to nearly 30 percent beyond the industry norm.

Effective reward and incentive systems share a number of common characteristics.31 (see Exhibit 9.4). The perception that a plan is “fair and equitable” is critically important.

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The firm must have the flexibility to respond to changing requirements as its direction and objectives change. In recent years many companies have begun to place more emphasis on growth. Emerson Electric has shifted its emphasis from cost cutting to growth. To ensure that changes take hold, the management compensation formula has been changed from a largely bottom-line focus to one that emphasizes growth, new products, acquisitions, and international expansion. Discussions about profits are handled separately, and a culture of risk taking is encouraged.32 Finally, incentive and reward systems don’t all have to be about financial rewards. Recognition can be a powerful motivator. For example, at Mars Central Europe, they hold an event twice a year in which they celebrate innovative ideas generated by employees. Recognition at the “Make a Difference” event is designed to motivate the winners and also other employees who want to receive the same recognition.33

EXHIBIT 9.4   Characteristics of Effective Reward and Evaluation Systems

•   Objectives are clear, well understood, and broadly accepted

•   Rewards are clearly linked to performance and desired behaviors.

•   Performance measures are clear and highly visible.

•   Feedback is prompt, clear, and unambiguous.

•   The compensation “system” is perceived as fair and equitable.

•   The structure is flexible; it can adapt to changing circumstances.

The key is for managers to find a mix of incentives that motivates employees. Gordon Bethune, the former CEO of Continental Airlines used the following analogy.34

“I own a twelve-hundred-acre ranch, and it’s got a seventy-acre lake. It’s wonderful. And do you know, in spite of all that, I still have to use bait when I fish? Can you believe it? The point is there’s got to be something in it for the fish, and it’s up to me to know what the fish like. It’s not up to them. So maybe if I learn enough about the fish and what they like, they might be easier to get in the boat and provide me a little recreation.”

Setting Boundaries and Constraints

In an ideal world, a strong culture and effective rewards should be sufficient to ensure that all individuals and subunits work toward the common goals and objectives of the whole organization.35 However, this is not usually the case. Counterproductive behavior can arise because of motivated self-interest, lack of a clear understanding of goals and objectives, or outright malfeasance. Boundaries and constraints can serve many useful purposes for organizations, including:

boundaries and constraints

rules that specify behaviors that are acceptable and unacceptable.

•   Focusing individual efforts on strategic priorities.

•   Providing short-term objectives and action plans to channel efforts.

•   Improving efficiency and effectiveness.

•   Minimizing improper and unethical conduct.

Focusing Efforts on Strategic Priorities Boundaries and constraints play a valuable role in focusing a company’s strategic priorities. For example, several years ago, IBM sold off its PC business as part of its desire to focus its business on computing services. Similarly, Pfizer sold its infant formula business as it refocused its attention on core pharmaceutical products.36 This concentration of effort and resources provides the firm with greater strategic focus and the potential for stronger competitive advantages in the remaining areas.

Steve Jobs would use white boards to set priorities and focus attention at Apple. For example, he would take his “top 100” people on a retreat each year. One year, he asked the group what 10 things Apple should do next. The group identified ideas. Ideas went up on the board, then got erased or revised; new ones were added, revised, and erased. The group argued about it for a while and finally identified their list of top 10 initiatives. Jobs proceeded to slash the bottom seven, stating, “We can only do three.”37

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Boundaries also have a place in the nonprofit sector. For example, a British relief organization uses a system to monitor strategic boundaries by maintaining a list of companies whose contributions it will neither solicit nor accept. Such boundaries are essential for maintaining legitimacy with existing and potential benefactors.

Providing Short-Term Objectives and Action Plans In Chapter 1 we discussed the importance of a firm having a vision, mission, and strategic objectives that are internally consistent and that provide strategic direction. In addition, short-term objectives and action plans provide similar benefits. That is, they represent boundaries that help to allocate resources in an optimal manner and to channel the efforts of employees at all levels throughout the organization.38 To be effective, short-term objectives must have several attributes. They should:

•   Be specific and measurable.

•   Include a specific time horizon for their attainment.

•   Be achievable, yet challenging enough to motivate managers who must strive to accomplish them.

Research has found that performance is enhanced when individuals are encouraged to attain specific, difficult, yet achievable, goals (as opposed to vague “do your best” goals).39

Short-term objectives must provide proper direction and also provide enough flexibility for the firm to keep pace with and anticipate changes in the external environment, new government regulations, a competitor introducing a substitute product, or changes in consumer taste. Unexpected events within a firm may require a firm to make important adjustments in both strategic and short-term objectives. The emergence of new industries can have a drastic effect on the demand for products and services in more traditional industries.

Action plans are critical to the implementation of chosen strategies. Unless action plans are specific, there may be little assurance that managers have thought through all of the resource requirements for implementing their strategies. In addition, unless plans are specific, managers may not understand what needs to be implemented or have a clear time frame for completion. This is essential for the scheduling of key activities that must be implemented. Finally, individual managers must be held accountable for the implementation. This helps to provide the necessary motivation and “sense of ownership” to implement action plans on a timely basis. Strategy Spotlight 9.2 illustrates how Marks and Spencer puts its sustainability mission into action by creating clear, measurable goals.

Improving Operational Efficiency and Effectiveness Rule-based controls are most appropriate in organizations with the following characteristics:

•   Environments are stable and predictable.

•   Employees are largely unskilled and interchangeable.

•   Consistency in product and service is critical.

•   The risk of malfeasance is extremely high (e.g., in banking or casino operations).40

McDonald’s Corp. has extensive rules and regulations that regulate the operation of its franchises.41 Its policy manual from a number of years ago stated, “Cooks must turn, never flip, hamburgers. If they haven’t been purchased, Big Macs must be discarded in 10 minutes after being cooked and French fries in 7 minutes. Cashiers must make eye contact with and smile at every customer.”

Guidelines can also be effective in setting spending limits and the range of discretion for employees and managers, such as the $2,500 limit that hotelier Ritz-Carlton uses to empower employees to placate dissatisfied customers. Regulations also can be initiated to improve the use of an employee’s time at work.42 CA Technologies restricts the use of email during the hours of 10 a.m. to noon and 2 p.m. to 4 p.m. each day.43

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STRATEGY SPOTLIGHT

9.2    ENVIRONMENTAL SUSTAINABILITY

BREAKING DOWN SUSTAINABILITY INTO MEASURABLE GOALS

Marks & Spencer (M&S) laid out an ambitious goal in early 2010 to become “the world’s most sustainable retailer” by 2015. To meet this goal, M&S needed to substantially change how it undertook nearly all of its business operations. To make this process more tractable and to provide opportunities to identify a range of actions managers could take, M&S developed an overarching plan for its sustainability efforts, dubbed Plan A. They called it Plan A because, as M&S managers put it, when it comes to building environmental sustainability, there is no Plan B. Everyone in the firm needed to be committed to the one vision. In this plan, M&S identified three broad themes.

•   Aim for all M&S products to have at least one Plan A quality.

•   Help our customers make a difference to the social and environmental causes that matter to them.

•   Help our customers live a more sustainable life.

Thus, M&S aimed not only to improve its own operations but also to change the lives of its customers and the operations of its suppliers and other partners. Marc Bolland, M&S’s CEO, fleshed out the general Plan A goal with 180 environmental commitments. These commitments all had time targets associated with them, some short term and some longer term. For example, one commitment was to make the company carbon neutral by 2012. To meet its goal, M&S estimated it needed to achieve a 25 percent reduction in energy use in its stores by 2012 and extended it to 35 percent by 2015. This provided clear targets for store managers to work toward. Similarly, M&S set a goal to improve its water use efficiency in stores by 25 percent by the year 2015. Additionally, M&S set out to design new stores that used 35 percent less water than current stores. These targets provided clear metrics for store managers as well as architects and designers working on new stores.

In working with its suppliers, M&S similarly rolled out a series of time-based commitments. For example, it conducted a review with all suppliers on the Plan A initiatives in the first year of the plan. M&S required all suppliers of fresh meat, dairy, produce, and flowers to engage in a sustainable agriculture program by 2012. All clothing suppliers were required to install energy efficient lighting and improved insulation by 2015 to attain a 10 percent reduction in energy usage. These types of efforts spanned across the firm and its supply chain.

With its Plan A, M&S broke down a huge initiative into clear targets that were actionable by managers across the firm and in its partner firms. Interestingly, while this initiative was hatched as a means to achieve environmental sustainability gains, it has also turned out to be an economic win for M&S. In the first year of the plan, the firm experienced an $80 million profit on the actions it undertook. The surplus has resulted from gains in energy efficiency, lower packaging costs, lower waste bills, and profit from a sustainable energy business it set up that relies on burning bio-waste to generate electricity.

Sources: Felsted, A. 2011. Marks and Spencer’s green blueprint. Ft.com , March 17: np; Anonymous. 2012. Marks & Spencer’s ambitious sustainability goals. Sustainablebusiness.com , March 3: np; and plana.marksandspencer.com.

Minimizing Improper and Unethical Conduct Guidelines can be useful in specifying proper relationships with a company’s customers and suppliers.44 Many companies have explicit rules regarding commercial practices, including the prohibition of any form of payment, bribe, or kickback. For example, Singapore Airlines has a 17-page policy outlining its anticorruption and antibribery policies.45

Regulations backed up with strong sanctions can also help an organization avoid conducting business in an unethical manner. After the passing of the Sarbanes-Oxley Act (which provides for stiffer penalties for financial reporting misdeeds), many chief financial officers (CFOs) have taken steps to ensure ethical behavior in the preparation of financial statements. For example, Home Depot’s CFO, Carol B. Tome, strengthened the firm’s code of ethics and developed stricter guidelines. Now all 25 of her subordinates must sign personal statements that all of their financial statements are correct—just as she and her CEO have to do.46

Behavioral Control in Organizations: Situational Factors

Here, the focus is on ensuring that the behavior of individuals at all levels of an organization is directed toward achieving organizational goals and objectives. The three fundamental types of control are culture, rewards and incentives, and boundaries and constraints. An organization may pursue one or a combination of them on the basis of a variety of internal and external factors.

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Not all organizations place the same emphasis on each type of control.47 In high-technology firms engaged in basic research, members may work under high levels of autonomy. An individual’s performance is generally quite difficult to measure accurately because of the long lead times involved in R&D activities. Thus, internalized norms and values become very important.

When the measurement of an individual’s output or performance is quite straightforward, control depends primarily on granting or withholding rewards. Frequently, a sales manager’s compensation is in the form of a commission and bonus tied directly to his or her sales volume, which is relatively easy to determine. Here, behavior is influenced more strongly by the attractiveness of the compensation than by the norms and values implicit in the organization’s culture. The measurability of output precludes the need for an elaborate system of rules to control behavior.48

Control in bureaucratic organizations is dependent on members following a highly formalized set of rules and regulations. Most activities are routine and the desired behavior can be specified in a detailed manner because there is generally little need for innovative or creative activity. Managing an assembly plant requires strict adherence to many rules as well as exacting sequences of assembly operations. In the public sector, the Department of Motor Vehicles in most states must follow clearly prescribed procedures when issuing or renewing driver licenses.

Exhibit 9.5 provides alternate approaches to behavioral control and some of the situational factors associated with them.

Evolving from Boundaries to Rewards and Culture

In most environments, organizations should strive to provide a system of rewards and incentives, coupled with a culture strong enough that boundaries become internalized. This reduces the need for external controls such as rules and regulations.

First, hire the right people—individuals who already identify with the organization’s dominant values and have attributes consistent with them. Kroger, a supermarket chain, uses a pre-employment test to assess the degree to which potential employees will be friendly and communicate well with customers.49 Microsoft’s David Pritchard is well aware of the consequences of failing to hire properly.

If I hire a bunch of bozos, it will hurt us, because it takes time to get rid of them. They start infiltrating the organization and then they themselves start hiring people of lower quality. At Microsoft, we are always looking for people who are better than we are.

EXHIBIT 9.5   Organizational Control: Alternative Approaches

Approach

Some Situational Factors

Culture: A system of unwritten rules that forms an internalized influence over behavior.

•   Often found in professional organizations.

 

•   Associated with high autonomy.

 

•   Norms are the basis for behavior.

Rules: Written and explicit guidelines that provide external constraints on behavior.

•   Associated with standardized output.

 

•   Tasks are generally repetitive and routine.

 

•   Little need for innovation or creative activity.

Rewards: The use of performance-based incentive systems to motivate.

•   Measurement of output and performance is rather straightforward.

 

•   Most appropriate in organizations pursuing unrelated diversification strategies.

 

•   Rewards may be used to reinforce other means of control.

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Second, training plays a key role. For example, in elite military units such as the Green Berets and Navy SEALs, the training regimen so thoroughly internalizes the culture that individuals, in effect, lose their identity. The group becomes the overriding concern and focal point of their energies. At firms such as FedEx, training not only builds skills, but also plays a significant role in building a strong culture on the foundation of each organization’s dominant values.

Third, managerial role models are vital. Andy Grove, former CEO and co-founder of Intel, didn’t need (or want) a large number of bureaucratic rules to determine who is responsible for what, who is supposed to talk to whom, and who gets to fly first class (no one does). He encouraged openness by not having many of the trappings of success—he worked in a cubicle like all the other professionals. Can you imagine any new manager asking whether or not he can fly first class? Grove’s personal example eliminated such a need.

Fourth, reward systems must be clearly aligned with the organizational goals and objectives. For example, as part of its efforts to drive sustainability efforts down through its suppliers, Marks and Spencer pushes the suppliers to develop employee rewards systems that support a living wage and team collaboration.

LO9.5

The three key participants in corporate governance: shareholders, management (led by the CEO), and the board of directors.

The Role of Corporate Governance

We now address the issue of strategic control in a broader perspective, typically referred to as “corporate governance.” Here we focus on the need for both shareholders (the owners of the corporation) and their elected representatives, the board of directors, to actively ensure that management fulfills its overriding purpose of increasing long-term shareholder value.50

Robert Monks and Nell Minow, two leading scholars in corporate governance, define it as “the relationship among various participants in determining the direction and performance of corporations. The primary participants are (1) the shareholders, (2) the management (led by the CEO), and (3) the board of directors.”* Our discussion will center on how corporations can succeed (or fail) in aligning managerial motives with the interests of the shareholders and their elected representatives, the board of directors.51 As you will recall from Chapter 1, we discussed the important role of boards of directors and provided some examples of effective and ineffective boards.52

Good corporate governance plays an important role in the investment decisions of major institutions, and a premium is often reflected in the price of securities of companies that practice it. The corporate governance premium is larger for firms in countries with sound corporate governance practices compared to countries with weaker corporate governance standards.53

Sound governance practices often lead to superior financial performance. However, this is not always the case. For example, practices such as independent directors (directors who are not part of the firm’s management) and stock options are generally assumed to result in better performance. But in many cases, independent directors may not have the necessary expertise or involvement, and the granting of stock options to the CEO may lead to decisions and actions calculated to prop up share price only in the short term. Strategy Spotlight 9.3 presents some research evidence on governance practices and firm performance.

corporate governance

the relationship among various participants in determining the direction and performance of corporations. The primary participants are (1) the share-holders, (2) the management, and (3) the board of directors.

*Management cannot ignore the demands of other important firm stakeholders such as creditors, suppliers, customers, employees, and government regulators. At times of financial duress, powerful creditors can exert strong and legitimate pressures on managerial decisions. In general, however, the attention to stakeholders other than the owners of the corporation must be addressed in a manner that is still consistent with maximizing long-term shareholder returns. For a seminal discussion on stakeholder management, refer to Freeman, R. E. 1984. Strategic Management: A Stakeholder Approach. Boston: Pitman.

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  STRATEGY SPOTLIGHT

9.3    ETHICS

THE RELATIONSHIP BETWEEN RECOMMENDED CORPORATE GOVERNANCE PRACTICES AND FIRM PERFORMANCE

A significant amount of research has examined the effect of corporate governance on firm performance. Some research has shown that implementing good corporate governance structures yields superior financial performance. Other research has not found a positive relationship between governance and performance. Results of a few of these studies are summarized below.

1.   A positive correlation between corporate governance and different measures of corporate performance. Recent studies show that there is a strong positive correlation between effective corporate governance and different indicators of corporate performance such as growth, profitability, and customer satisfaction. Over a recent three-year period, the average return of large capitalized firms with the best governance practices was more than five times higher than the performance of firms in the bottom corporate governance quartile.

2.   Compliance with international best practices leads to superior performance. Studies of European companies show that greater compliance with international corporate governance best practices concerning board structure and function has significant and positive relationships with return on assets (ROA). In 10 of 11 Asian and Latin American markets, companies in the top corporate governance quartile for their respective regions averaged 10 percent greater return on capital employed (ROCE) than their peers. In a study of 12 emerging markets, companies in the lowest corporate governance quartile had a much lower ROCE than their peers.

3.   Many recommended corporate governance practices do not have a positive relationship with firm performance. In contrast to these studies, there is also a body of research suggesting that corporate governance practices do not have a positive influence on firm performance. With corporate boards, there is no evidence that including more external directors on the board of directors of U.S. corporations has led to substantially higher firm performance. Also, giving more stock options to CEOs to align their interests with stakeholders may lead them to take high-risk bets in firm investments that have a low probability to improve firm performance. Rather than making good decisions, CEOs may “swing for the fences” with these high-risk investments. Additionally, motivating CEOs with large numbers of stock options appears to increase the likelihood of unethical accounting violations by the firm as the CEO tries to increase the firm’s stock price.

Sources: Dalton, D. R., Daily, C. M., Ellstrand, A. E., & Johnson, J. L., 1998. Meta-analytic reviews of board composition, leadership structure, and financial performance. Strategic Management Journal, 19(3): 269–290; Sanders, W. G. & Hambrick, D. C. 2007. Swinging for the fences: The effects of CEO stock options on company risk-taking and performance. Academy of Management Journal, 50(5): 1055–1078; Harris, J. & Bromiley, P. 2007. Incentives to cheat: The influence of executive compensation and firm performance on financial misrepresentation. Organization Science, 18(3): 350–367; Bauwhede, H. V. 2009. On the relation between corporate governance compliance and operating performance. Accounting and Business Research. 39(5): 497–513; Gill, A. 2001. Credit Lyonnais Securities (Asia). Corporate governance in emerging markets: Saints and sinners, April; and Low, C. K. 2002. Corporate governance: An Asia-Pacific critique. Hong Kong: Sweet & Maxwell Asia.

At the same time, few topics in the business press are generating as much interest (and disdain!) as corporate governance.

Some recent notable examples of flawed corporate governance include:54

•   In 2012 Japanese camera and medical equipment maker Olympus Corporation and three of its former executives pleaded guilty to charges that they falsified accounting records over a five-year period to inflate the financial performance of the firm. The total value of the accounting irregularities came to $1.7 billion.55

•   In October 2010, Angelo Mozilo, the co-founder of Countrywide Financial, agreed to pay $67.5 million to the Securities and Exchange Commission (SEC) to settle fraud charges. He was charged with deceiving the home loan company’s investors while reaping a personal windfall. He was accused of hiding risks about Countrywide’s loan portfolio as the real estate market soured. Former Countrywide President David Sambol and former Chief Financial Officer Eric Sieracki were also charged with fraud, as they failed to disclose the true state of Countrywide’s deteriorating mortgage portfolio. The SEC accused Mozilo of insider trading, alleging that he sold millions of dollars worth of Countrywide stock after he knew the company was doomed.

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•   In 2008, former Brocade CEO Gregory Reyes was sentenced to 21 months in prison and fined $15 million for his involvement in backdating stock option grants. Mr. Reyes was the first executive to go on trial and be convicted over the improper dating of stock-option awards, which dozens of companies have acknowledged since the practice came to light.

Because of the many lapses in corporate governance, we can see the benefits associated with effective practices.56 However, corporate managers may behave in their own self-interest, often to the detriment of shareholders. Next we address the implications of the separation of ownership and management in the modern corporation, and some mechanisms that can be used to ensure consistency (or alignment) between the interests of shareholders and those of the managers to minimize potential conflicts.

The Modern Corporation: The Separation of Owners (Shareholders) and Management

Some of the proposed definitions for a corporation include:

•   “The business corporation is an instrument through which capital is assembled for the activities of producing and distributing goods and services and making investments. Accordingly, a basic premise of corporation law is that a business corporation should have as its objective the conduct of such activities with a view to enhancing the corporation’s profit and the gains of the corporation’s owners, that is, the shareholders.” (Melvin Aron Eisenberg, The Structure of Corporation Law)

•   “A body of persons granted a charter legally recognizing them as a separate entity having its own rights, privileges, and liabilities distinct from those of its members.” (American Heritage Dictionary)

•   “An ingenious device for obtaining individual profit without individual responsibility.” (Ambrose Bierce, The Devil’s Dictionary)57

All of these definitions have some validity and each one reflects a key feature of the corporate form of business organization—its ability to draw resources from a variety of groups and establish and maintain its own persona that is separate from all of them. As Henry Ford once said, “A great business is really too big to be human.”

Simply put, a corporation is a mechanism created to allow different parties to contribute capital, expertise, and labor for the maximum benefit of each party.58 The shareholders (investors) are able to participate in the profits of the enterprise without taking direct responsibility for the operations. The management can run the company without the responsibility of personally providing the funds. The shareholders have limited liability as well as rather limited involvement in the company’s affairs. However, they reserve the right to elect directors who have the fiduciary obligation to protect their interests.

corporation

a mechanism created to allow different parties to contribute capital, expertise, and labor for the maximum benefit of each party.

Over 75 years ago, Columbia University professors Adolf Berle and Gardiner C. Means addressed the divergence of the interests of the owners of the corporation from the professional managers who are hired to run it. They warned that widely dispersed ownership “released management from the overriding requirement that it serve stockholders.” The separation of ownership from management has given rise to a set of ideas called “agency theory.” Central to agency theory is the relationship between two primary players—the principals who are the owners of the firm (stockholders) and the agents, who are the people paid by principals to perform a job on their behalf (management). The stockholders elect and are represented by a board of directors that has a fiduciary responsibility to ensure that management acts in the best interests of stockholders to ensure long-term financial returns for the firm.

Agency theory is concerned with resolving two problems that can occur in agency relationships.59 The first is the agency problem that arises (1) when the goals of the principals

agency theory

a theory of the relationship between principals and their agents, with emphasis on two problems: (1) the conflicting goals of principals and agents, along with the difficulty of principals to monitor the agents, and (2) the different attitudes and preferences toward risk of principals and agents.

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and agents conflict, and (2) when it is difficult or expensive for the principal to verify what the agent is actually doing. 60 The board of directors would be unable to confirm that the managers were actually acting in the shareholders’ interests because managers are “insiders” with regard to the businesses they operate and thus are better informed than the principals. Thus, managers may act “opportunistically” in pursuing their own interests—to the detriment of the corporation.61 Managers may spend corporate funds on expensive perquisites (e.g., company jets and expensive art), devote time and resources to pet projects (initiatives in which they have a personal interest but that have limited market potential), engage in power struggles (where they may fight over resources for their own betterment and to the detriment of the firm), and negate (or sabotage) attractive merger offers because they may result in increased employment risk.62

The second issue is the problem of risk sharing. This arises when the principal and the agent have different attitudes and preferences toward risk. The executives in a firm may favor additional diversification initiatives because, by their very nature, they increase the size of the firm and thus the level of executive compensation.63 At the same time, such diversification initiatives may erode shareholder value because they fail to achieve some synergies that we discussed in Chapter 6 (e.g., building on core competencies, sharing activities, or enhancing market power). Agents (executives) may have a stronger preference toward diversification than shareholders because it reduces their personal level of risk from potential loss of employment. Executives who have large holdings of stock in their firms were more likely to have diversification strategies that were more consistent with shareholder interests—increasing long-term returns.64

At times, top-level managers engage in actions that reflect their self-interest rather than the interests of shareholders. We provide two examples below:

•   Steve Wynn, the CEO of Wynn Resorts, had a great year in 2011, even though his stockholders barely broke even. He received a starting salary of $3.9 million. On top of that, he received two bonuses, one worth $2 million and another for $9 million. In addition to cash compensation, he received over $900,000 worth of personal flying time on the corporate jet and over $500,000 worth of use of the company’s villa.65

•   John Sperling retired as chairman emeritus of Apollo Group in early 2013. He founded Apollo, the for-profit education company best known for its University of Phoenix unit, in 1973. Even though he already owns stock in Apollo worth in excess of $200 million, the board of directors, which includes his son as a member, granted him a “special retirement bonus” of $5 million, gave him two cars, and awarded him a lifetime annuity of $71,000 a month. He received all of these benefits even though Apollo’s stock at the time of his retirement was worth one-fourth of its value in early 2009.66

Governance Mechanisms: Aligning the Interests of Owners and Managers

As noted above, a key characteristic of the modern corporation is the separation of ownership from control. To minimize the potential for managers to act in their own self-interest, or “opportunistically,” the owners can implement some governance mechanisms.67 First, there are two primary means of monitoring the behavior of managers. These include (1) a committed and involved board of directors that acts in the best interests of the shareholders to create long-term value and (2) shareholder activism, wherein the owners view themselves as shareowners instead of shareholders and become actively engaged in the governance of the corporation. Finally, there are managerial incentives, sometimes called “contract-based outcomes,” which consist of reward and compensation agreements. Here the goal is to carefully craft managerial incentive packages to align the interests of management with those of the stockholders.68

LO9.6

The role of corporate governance mechanisms in ensuring that the interests of managers are aligned with those of shareholders from both the United States and international perspectives.

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We close this section with a brief discussion of one of the most controversial issues in corporate governance—duality. Here, the question becomes: Should the CEO also be chairman of the board of directors? In many Fortune 500 firms, the same individual serves in both roles. However, in recent years, we have seen a trend toward separating these two positions. The key issue is what implications CEO duality has for firm governance and performance.

A Committed and Involved Board of Directors The board of directors acts as a fulcrum between the owners and controllers of a corporation. They are the intermediaries who provide a balance between a small group of key managers in the firm based at the corporate headquarters and a sometimes vast group of shareholders.69 In the United States, the law imposes on the board a strict and absolute fiduciary duty to ensure that a company is run consistent with the long-term interests of the owners—the shareholders. The reality, as we have seen, is somewhat more ambiguous.70

board of directors

a group that has a fiduciary duty to ensure that the company is run consistently with the long-term interests of the owners, or shareholders, of a corporation and that acts as an intermediary between the shareholders and management.

The Business Roundtable, representing the largest U.S. corporations, describes the duties of the board as follows:

1.   Select, regularly evaluate, and, if necessary, replace the CEO. Determine management compensation. Review succession planning.

2.   Review and, where appropriate, approve the financial objectives, major strategies, and plans of the corporation.

3.   Provide advice and counsel to top management.

4.   Select and recommend to shareholders for election an appropriate slate of candidates for the board of directors; evaluate board processes and performance.

5.   Review the adequacy of the systems to comply with all applicable laws/regulations.71

Given these principles, what makes for a good board of directors?72 According to the Business Roundtable, the most important quality is a board of directors who are active, critical participants in determining a company’s strategies.73 That does not mean board members should micromanage or circumvent the CEO. Rather, they should provide strong oversight going beyond simply approving the CEO’s plans. A board’s primary responsibilities are to ensure that strategic plans undergo rigorous scrutiny, evaluate managers against high performance standards, and take control of the succession process.74

Although boards in the past were often dismissed as CEO’s rubber stamps, increasingly they are playing a more active role by forcing out CEOs who cannot deliver on performance.75 According to the consulting firm Booz Allen Hamilton, the rate of CEO departures for performance reasons more than tripled, from 1.3 percent to 4.2 percent, between 1995 and 2002.76 And today’s CEOs are not immune to termination.

•   In September 2010, Jonathan Klein, the president of the CNN/U.S. cable channel, was fired because CNN’s ratings had suffered.77

•   Don Blankenship, CEO of coal mining giant Massey Energy, resigned in December 2010 after a deadly explosion in Massey’s Upper Big Branch mine in West Virginia, a mine that had received numerous citations for safety violations in the last few years. The blast was the worst mining disaster in the United States in 40 years and resulted in criminal as well as civil investigations and lawsuits.

•   Tony Hayward, CEO of oil and energy company British Petroleum (BP), was forced to step down in October 2010 after the Deepwater Horizon oil spill in the Gulf of Mexico led to an environmental disaster and a $20 billion recovery fund financed by BP.

•   Carol Bartz was ousted as the CEO of Yahoo after two and a half years when the board observed limited improvement in the firm’s market position, turmoil over job cuts and secrecy during her leadership, and a flat stock price. Similarly, Vikram Pandit was pressured to resign from his position as CEO of Citigroup after five tumultuous years and increasing investor unhappiness over the performance of the firm.

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Increasing CEO turnover could, however, pose a major problem for many organizations. Why? It appears that boards of directors are not typically engaged in effective succession planning. For example, only 35 percent of 1,318 executives surveyed by Korn/Ferry International in December 2010 said their companies had a succession plan. And 61 percent of respondents to a survey (conducted by Heidrick & Struggles and Stanford University’s Rock Center for Corporate Governance) claimed their companies had no viable internal candidates. This issue is also true in private companies. Only 23 percent of private firms surveyed by the National Association of Corporate Directors indicated they had developed formal succession plans.78

Another key component of top-ranked boards is director independence.79 Governance experts believe that a majority of directors should be free of all ties to either the CEO or the company.80 That means a minimum of “insiders” (past or present members of the management team) should serve on the board, and that directors and their firms should be barred from doing consulting, legal, or other work for the company.81 Interlocking directorships—in which CEOs and other top managers serve on each other’s boards—are not desirable. But perhaps the best guarantee that directors act in the best interests of shareholders is the simplest: Most good companies now insist that directors own significant stock in the company they oversee.82

Taking it one step further, research and simple observations of boards indicate that simple prescriptions, such as having a majority of outside directors, are insufficient to lead to effective board operations. Firms need to cultivate engaged and committed boards. There are several actions that can have a positive influence on board dynamics as the board works to both oversee and advise management.83

1.   Build in the right expertise on the board. Outside directors can bring in experience that the management team is missing. For example, corporations that are considering expanding into a new region of the globe may want to add a board member who brings expertise on and connections in that region. Similarly, research suggests that firms who are focusing on improving their operational efficiency benefit from having an external board member whose full time position is as a chief operating officer, a position that typically focuses on operational activities.

2.   Keep your board size manageable. Small, focused boards, generally with 5 to 11 members, are preferable to larger ones. As boards grow in size, the ability for them to function as a team declines. The members of the board feel less connected with each other, and decision making can become unwieldy.

3.   Choose directors who can participate fully. The time demands on directors have increased as their responsibilities have grown to include overseeing management, verifying the firm’s financial statements, setting executive compensation, and advising on the strategic direction of the firm. As a result, the average number of hours per year spent on board duties has increased to over 350 hours for directors of large firms. Directors have to dedicate significant time to their roles—not just for scheduled meetings, but also to review materials between meetings and to respond to time-sensitive challenges. Thus, firms should strive to include directors who are not currently overburdened by their core occupation or involvement on other boards.

4.   Balance the need to focus on the past, the present, and the future. Boards have a three-tiered role. They need to focus on the recent performance of the firm, how the firm is meeting current milestones and operational targets, and what the strategic direction of the firm will be moving forward. Under current regulations, boards are required to spend a great amount of time on the past as they vet the firm’s financials. However, effective boards balance this time and ensure that they give adequate consideration to the present and the future.

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5.   Consider management talent development. As part of their future-oriented focus, effective boards develop succession plans for the CEO but also focus on talent development at other upper echelons of the organization. In a range of industries, human capital is an increasingly important driver of firm success, and boards should be involved in evaluating and developing the top management core.

6.   Get a broad view. In order to better understand the firm and make contact with key managers, the meetings of the board should rotate to different operating units and sites of the firm.

7.   Maintain norms of transparency and trust. Highly functioning boards maintain open, team-oriented dialogue where information flows freely and questions are asked openly. Directors respect each other and trust that they are all working in the best interests of the corporation.

With financial crises and corporate scandals, regulators and investors have pushed for significant changes in the structure and actions of boards. Exhibit 9.6 highlights some of the changes seen among firms in the S&P 500.

EXHIBIT 9.6   The Changing Face of the Board of Firms in the S&P 500

Then and Now

Issue

1987

2011

Explanation

Percentage of boards that have an average age of 64 or older

3

37

Fewer sitting CEOs are willing to serve on the boards of other firms. As a result, companies are raising the retirement age for directors and pulling in retired executives to their boards.

Average pay for directors

$36,667

$95,262

Board work has taken greater time and commitment. Additionally, the personal liability directors face has increased. As a result, compensation has increased to attract and retain board members.

Percentage of board members who are female

9

16.2

While the number of boards with women and minorities has increased, these groups are still underrepresented. Still, companies have emphasized including female directors in key roles. For example, over half the audit and compensation committees of S&P 500 firms have at least one female member.

Percentage of boards with 12 or fewer members

22

83

As the strategic role and the legal requirements of the board have increased, firms have opted for smaller boards since these smaller boards better operate as true decision-making groups.

Percentage of the directors that are independent

68

84

The Sarbanes-Oxley Act and pressure from investors have led to an increase in the number of independent directors. In fact, over half the S&P 500 firms now have no insiders other than the CEO on the board.

Sources: Anonymous. 2011. Corporate boards: Now and then. Harvard Business Review, 89(11): 38–39; and Dalton, D. & Dalton, C. 2010. Women and corporate boards of directors: The promise of increased, and substantive participation in the post Sarbanes-Oxley era. Business Horizons, 53: 257–268.

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Shareholder Activism As a practical matter, there are so many owners of the largest American corporations that it makes little sense to refer to them as “owners” in the sense of individuals becoming informed and involved in corporate affairs.84 However, even an individual shareholder has several rights, including (1) the right to sell the stock, (2) the right to vote the proxy (which includes the election of board members), (3) the right to bring suit for damages if the corporation’s directors or managers fail to meet their obligations, (4) the right to certain information from the company, and (5) certain residual rights following the company’s liquidation (or its filing for reorganization under bankruptcy laws), once creditors and other claimants are paid off.85

Collectively, shareholders have the power to direct the course of corporations.86 This may involve acts such as being party to shareholder action suits and demanding that key issues be brought up for proxy votes at annual board meetings.87 The power of shareholders has intensified in recent years because of the increasing influence of large institutional investors such as mutual funds (e.g., T. Rowe Price and Fidelity Investments) and retirement systems such as TIAA-CREF (for university faculty members and school administrative staff).88 Institutional investors hold approximately 50 percent of all listed corporate stock in the United States.89

Shareholder activism refers to actions by large shareholders, both institutions and individuals, to protect their interests when they feel that managerial actions diverge from shareholder value maximization.

shareholder activism

actions by large shareholders to protect their interests when they feel that managerial actions of a corporation diverge from shareholder value maximization.

Many institutional investors are aggressive in protecting and enhancing their investments. They are shifting from traders to owners. They are assuming the role of permanent shareholders and rigorously analyzing issues of corporate governance. In the process they are reinventing systems of corporate monitoring and accountability.90

Consider the proactive behavior of CalPERS, the California Public Employees’ Retirement System, which manages over $240 billion in assets and is the third largest pension fund in the world. Every year CalPERS reviews the performance of the 1,000 firms in which it retains a sizable investment.91 They review each firm’s short- and long-term performance, its governance characteristics, its financial status, and market expectations for the firm. CalPERS then meets with selected companies to better understand their governance and business strategy. If needed, CalPERS requests changes in the firm’s governance structure and works to ensure shareholders’ rights. If CalPERS does not believe that the firm is responsive to its concerns, they consider filing proxy actions at the firm’s next shareholders meeting and possibly even court actions. CalPERS’s research suggests that these actions lead to superior performance. The portfolio of firms they have included in their review program produced a cumulative return that was 11.59 percent higher than a respective set of benchmark firms over a three-year period. Thus, CalPERS has seen a real benefit of acting as an interested owner, rather than as a passive investor.

Perhaps no discussion of shareholder activism would be complete without mention of Carl Icahn, a famed activist with a personal net worth of about $13 billion:

The bogeyman I am now chasing is the structure of American corporations, which permit managements and boards to rule arbitrarily and too often receive egregious compensation even after doing a subpar job. Yet they remain accountable to no one.92

The market appears to value the actions of activist investors. On the day it became publicly known that Icahn had taken a 10 percent ownership in Netflix, the stock price of Netflix soared 14 percent.93

Managerial Rewards and Incentives As we discussed earlier in the chapter, incentive systems must be designed to help a company achieve its goals.94 From the perspective of governance, one of the most critical roles of the board of directors is to create incentives that align the interests of the CEO and top executives with the interests of owners of the

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corporation—long-term shareholder returns.95 Shareholders rely on CEOs to adopt policies and strategies that maximize the value of their shares.96 A combination of three basic policies may create the right monetary incentives for CEOs to maximize the value of their companies:97

1.   Boards can require that the CEOs become substantial owners of company stock.

2.   Salaries, bonuses, and stock options can be structured so as to provide rewards for superior performance and penalties for poor performance.

3.   Dismissal for poor performance should be a realistic threat.

In recent years the granting of stock options has enabled top executives of publicly held corporations to earn enormous levels of compensation. In 2011, the average CEO in the Standard & Poor’s 500 stock index took home 380 times the pay of the average worker—up from 40 times the average in 1980. The counterargument, that the ratio is down from the 514 multiple in 2000, doesn’t get much traction.98

Many boards have awarded huge option grants despite poor executive performance, and others have made performance goals easier to reach. However, stock options can be a valuable governance mechanism to align the CEO’s interests with those of the shareholders. The extraordinarily high level of compensation can, at times, be grounded in sound governance principles.99 Research by Steven Kaplan at the University of Chicago found that firms with CEOs in the top quintile of pay generated stock returns 60 percent higher than their direct competitors, while firms with CEOs in the bottom quintile of pay saw their stock underperform their rivals by almost 20 percent.100 For example, David Zaslav CEO of Discovery Communications, took home $37.8 million in 2011, but his firm’s stock appreciated by 57 percent over the 2011–2012 period.101

That doesn’t mean that executive compensation systems can’t or shouldn’t be improved. Exhibit 9.7 outlines a number of ways to build effective compensation packages for executives.102

EXHIBIT 9.7   Six Policies for Effective TopManagement Compensation

Boards need to be diligent in building executive compensation packages that will incentivize executives to build long-term shareholder value and to address the concerns that regulators and the public have about excessive compensation. The key is to have open, fair, and consistent pay plans. Here are five policies to achieve that

1.   Increase transparency. Principles and pay policies should be consistent over time and fully disclosed in company documents. For example, Novartis has emphasized making their compensation policies fully transparent and not altering the targets used for incentive compensation in midstream.

2.   Build long-term performance with long-term pay. The timing of compensation can be structured to force executives to think about the long-term success of the organization. For example, ExxonMobil times two-thirds of its senior executives’ incentive compensation so that they don’t receive it until they retire or for 10 years, whichever is longer. Similarly, in 2009, Goldman Sachs replaced its annual bonuses for its top managers with restricted stock grants that executives could sell in three to five years.

3.   Reward executives for performance, not simply for changes in the company’s stock price. To keep them from focusing only on stock price, Target includes a component in its executives’ compensation plan for same-store sales performance over time.

4.   Have executives put some “skin in the game.” Firms should create some downside risk for managers. Relying more on restricted stock, rather than stock options, can achieve this. But some experts suggest that top executives should purchase sizable blocks of the firm’s stock with their own money.

5.   Avoid overreliance on simple metrics. Rather than rewarding for short-term financial performance metrics, firms should include future-oriented qualitative measures to incentivize managers to build for the future. Companies could include criteria such as customer retention rates, innovation and new product launch milestones, and leadership development criteria. For example, IBM added bonuses for executives who evidenced actions fostering global cooperation.

6.   Increase equity between workers and executives. Top executives, with their greater responsibilities, should and will continue to make more than front-line employees, but firms can signal equity by dropping special perks, plans, and benefits for top managers. Additionally, companies can give employees the opportunity to share in the success of the firm by establishing employee stock ownership plans.

Sources: George, B. 2010. Executive pay: Rebuilding trust in an era of rage. Bloomberg Businessweek, September 13: 56; and Barton, D. 2011. Capitalism for the long term. Harvard Business Review, 89(3): 85.

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CEO Duality: Is It Good or Bad?

CEO duality is one of the most controversial issues in corporate governance. It refers to the dual leadership structure where the CEO acts simultaneously as the chair of the board of directors.103 Scholars, consultants, and executives who are interested in determining the best way to manage a corporation are divided on the issue of the roles and responsibilities of a CEO. Two schools of thought represent the alternative positions:

Unity of Command Advocates of the unity of command perspective believe when one person holds both roles, he or she is able to act more efficiently and effectively. CEO duality provides firms with a clear focus on both objectives and operations as well as eliminates confusion and conflict between the CEO and the chairman. Thus, it enables smoother, more effective strategic decision making. Holding dual roles as CEO/chairman creates unity across a company’s managers and board of directors and ultimately allows the CEO to serve the shareholders even better. Having leadership focused in a single individual also enhances a firm’s responsiveness and ability to secure critical resources. This perspective maintains that separating the two jobs—that of a CEO and that of the chairperson of the board of directors—may produce all types of undesirable consequences. CEOs may find it harder to make quick decisions. Ego-driven chief executives and chairmen may squabble over who is ultimately in charge. The shortage of first-class business talent may mean that bosses find themselves second-guessed by people who know little about the business.104 Companies like Coca-Cola, JPMorgan Chase, and Time Warner have refused to divide the CEO’s and chairman’s jobs and support this duality structure.

Agency Theory Supporters of agency theory argue that the positions of CEO and chairman should be separate. The case for separation is based on the simple principle of the separation of power. How can boards discharge their basic duty—monitoring the boss—if the boss is chairing its meetings and setting its agenda? How can a board act as a safeguard against corruption or incompetence when the possible source of that corruption and incompetence is sitting at the head of the table? CEO duality can create a conflict of interest that could negatively affect the interests of the shareholders.

Duality also complicates the issue of CEO succession. In some cases, a CEO/chairman may choose to retire as CEO but keep his or her role as the chairman. Although this splits up the roles, which appeases an agency perspective, it nonetheless puts the new CEO in a difficult position. The chairman is bound to question some of the new changes put in place, and the board as a whole might take sides with the chairman they trust and with whom they have a history. This conflict of interest would make it difficult for the new CEO to institute any changes, as the power and influence would still remain with the former CEO.105

Duality also serves to reinforce popular doubts about the legitimacy of the system as a whole and evokes images of bosses writing their own performance reviews and setting their own salaries. One of the first things that some of America’s troubled banks, including Citigroup, Washington Mutual, Wachovia, and Wells Fargo, did when the financial crisis hit in 2007–2008 was to separate the two jobs. Firms like Siebel Systems, Disney, Oracle, and Microsoft have also decided to divide the roles between the CEO and chairman and eliminate duality. Finally, more than 90 percent of S&P 500 companies with CEOs who also serve as chairman of the board have appointed “lead” or “presiding” directors to act as a counterweight to a combined chairman and chief executive.

Research suggests that the effects of going from having a joint CEO/Chairman to separating the two positions is contingent on how the firm is doing. When the positions are broken apart, there is a clear shift in the firm’s performance. If the firm has been performing well, its performance declines after the separation. If the firm has been doing poorly, it

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experiences improvement after separating the two roles. This research suggests that there is no one correct answer on duality, but that firms should consider its current position and performance trends when deciding whether to keep the CEO and Chairman position in the hands of one person.106

External Governance Control Mechanisms

Thus far, we’ve discussed internal governance mechanisms. Internal controls, however, are not always enough to ensure good governance. The separation of ownership and control that we discussed earlier requires multiple control mechanisms, some internal and some external, to ensure that managerial actions lead to shareholder value maximization. Further, society-at-large wants some assurance that this goal is met without harming other stakeholder groups. Now we discuss several external governance control mechanisms that have developed in most modern economies. These include the market for corporate control, auditors, governmental regulatory bodies, banks and analysts, media, and public activists.

external governance control mechanisms

methods that ensure that managerial actions lead to shareholder value maximization and do not harm other stakeholder groups that are outside the control of the corporate governance system.

The Market for Corporate Control Let us assume for a moment that internal control mechanisms in a company are failing. This means that the board is ineffective in monitoring managers and is not exercising the oversight required of them and that shareholders are passive and are not taking any actions to monitor or discipline managers. Under these circumstances managers may behave opportunistically.107 Opportunistic behavior can take many forms. First, they can shirk their responsibilities. Shirking means that managers fail to exert themselves fully, as is required of them. Second, they can engage in on the job consumption. Examples of on the job consumption include private jets, club memberships, expensive artwork in the offices, and so on. Each of these represents consumption by managers that does not in any way increase shareholder value. Instead, they actually diminish shareholder value. Third, managers may engage in excessive product-market diversification. 108 As we discussed in Chapter 6, such diversification serves to reduce only the employment risk of the managers rather than the financial risk of the shareholders, who can more cheaply diversify their risk by owning a portfolio of investments. Is there any external mechanism to stop managers from shirking, consumption on the job, and excessive diversification?

The market for corporate control is one external mechanism that provides at least some partial solution to the problems described. If internal control mechanisms fail and the management is behaving opportunistically, the likely response of most shareholders will be to sell their stock rather than engage in activism.109 As more stockholders vote with their feet, the value of the stock begins to decline. As the decline continues, at some point the market value of the firm becomes less than the book value. A corporate raider can take over the company for a price less than the book value of the assets of the company. The first thing that the raider may do on assuming control over the company will be to fire the underperforming management. The risk of being acquired by a hostile raider is often referred to as the takeover constraint. The takeover constraint deters management from engaging in opportunistic behavior.110

market for corporate control

an external control mechanism in which shareholders dissatisfied with a firm’s management sell their shares.

takeover constraint

the risk to management of the firm being acquired by a hostile raider.

Although in theory the takeover constraint is supposed to limit managerial opportunism, in recent years its effectiveness has become diluted as a result of a number of defense tactics adopted by incumbent management (see Chapter 6). Foremost among them are poison pills, greenmail, and golden parachutes. Poison pills are provisions adopted by the company to reduce its worth to the acquirer. An example would be payment of a huge one-time dividend, typically financed by debt. Greenmail involves buying back the stock from the acquirer, usually at an attractive premium. Golden parachutes are employment contracts that cause the company to pay lucrative severance packages to top managers fired as a result of a takeover, often running to several million dollars.

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Auditors Even when there are stringent disclosure requirements, there is no guarantee that the information disclosed will be accurate. Managers may deliberately disclose false information or withhold negative financial information as well as use accounting methods that distort results based on highly subjective interpretations. Therefore, all accounting statements are required to be audited and certified to be accurate by external auditors. These auditing firms are independent organizations staffed by certified professionals who verify the firm’s books of accounts. Audits can unearth financial irregularities and ensure that financial reporting by the firm conforms to standard accounting practices.

However, these audits often fail to catch accounting irregularities. In the past, auditing failures played an important part in the failures of firms such as Enron and WorldCom. A recent study by the Public Company Accounting Oversight Board (PCAOB) found that audits conducted by the Big 4 accounting firms were often deficient. For example, 20 percent of the Ernst & Young audits examined by the PCAOB failed. And this was the best of the Big 4! The PCAOB found fault with 45 percent of the Deloitte audits it examined. Why do these reputable firms fail to find all of the issues in audits they conduct? First, auditors are appointed by the firm being audited. The desire to continue that business relationship sometimes makes them overlook financial irregularities. Second, most auditing firms also do consulting work and often have lucrative consulting contracts with the firms that they audit. Understandably, some of them tend not to ask too many difficult questions, because they fear jeopardizing the consulting business, which is often more profitable than the auditing work.

Banks and Analysts Commercial and investment banks have lent money to corporations and therefore have to ensure that the borrowing firm’s finances are in order and that the loan covenants are being followed. Stock analysts conduct ongoing in-depth studies of the firms that they follow and make recommendations to their clients to buy, hold, or sell. Their rewards and reputation depend on the quality of these recommendations. Their access to information, knowledge of the industry and the firm, and the insights they gain from interactions with the management of the company enable them to alert the investing community of both positive and negative developments relating to a company.

It is generally observed that analyst recommendations are often more optimistic than warranted by facts. “Sell” recommendations tend to be exceptions rather than the norm. Many analysts failed to grasp the gravity of the problems surrounding failed companies such as Lehman Brothers and Countrywide till the very end. Part of the explanation may lie in the fact that most analysts work for firms that also have investment banking relationships with the companies they follow. Negative recommendations by analysts can displease the management, who may decide to take their investment banking business to a rival firm. Otherwise independent and competent analysts may be pressured to overlook negative information or tone down their criticism.

Regulatory Bodies The extent of government regulation is often a function of the type of industry. Banks, utilities, and pharmaceuticals are subject to more regulatory oversight because of their importance to society. Public corporations are subject to more regulatory requirements than private corporations.111

All public corporations are required to disclose a substantial amount of financial information by bodies such as the Securities and Exchange Commission. These include quarterly and annual filings of financial performance, stock trading by insiders, and details of executive compensation packages. There are two primary reasons behind such requirements. First, markets can operate efficiently only when the investing public has faith in the market system. In the absence of disclosure requirements, the average investor suffers from a lack of reliable information and therefore may completely stay

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away from the capital market. This will negatively impact an economy’s ability to grow. Second, disclosure of information such as insider trading protects the small investor to some extent from the negative consequences of information asymmetry. The insiders and large investors typically have more information than the small investor and can therefore use that information to buy or sell before the information becomes public knowledge.

The failure of a variety of external control mechanisms led the U.S. Congress to pass the Sarbanes-Oxley Act in 2002. This act calls for many stringent measures that would ensure better governance of U.S. corporations. Some of these measures include:112

•    Auditors are barred from certain types of nonaudit work. They are not allowed to destroy records for five years. Lead partners auditing a client should be changed at least every five years.

•    CEOs and CFOs must fully reveal off-balance-sheet finances and vouch for the accuracy of the information revealed.

•    Executives must promptly reveal the sale of shares in firms they manage and are not allowed to sell when other employees cannot.

•    Corporate lawyers must report to senior managers any violations of securities law lower down.

Media and Public Activists The press is not usually recognized as an external control mechanism in the literature on corporate governance. There is no denying that in all developed capitalist economies, the financial press and media play an important indirect role in monitoring the management of public corporations. In the United States, business magazines such as Bloomberg Businessweek and Fortune, financial newspapers such as The Wall Street Journal and Investors Business Daily, as well as television networks like Fox Business Network and CNBC are constantly reporting on companies. Public perceptions about a company’s financial prospects and the quality of its management are greatly influenced by the media. Food Lion’s reputation was sullied when ABC’s Prime Time Live in 1992 charged the company with employee exploitation, false package dating, and unsanitary meat handling practices. Bethany McLean of Fortune magazine is often credited as the first to raise questions about Enron’s long-term financial viability.113

Similarly, consumer groups and activist individuals often take a crusading role in exposing corporate malfeasance.114 Well-known examples include Ralph Nader and Erin Brockovich, who played important roles in bringing to light the safety issues related to GM’s Corvair and environmental pollution issues concerning Pacific Gas and Electric Company, respectively. Ralph Nader has created over 30 watchdog groups, including:115

•    Aviation Consumer Action Project. Works to propose new rules to prevent flight delays, impose penalties for deceiving passengers about problems, and push for higher compensation for lost luggage.

•    Center for Auto Safety. Helps consumers find plaintiff lawyers and agitate for vehicle recalls, increased highway safety standards, and lemon laws.

•    Center for Study of Responsive Law. This is Nader’s headquarters. Home of a consumer project on technology, this group sponsored seminars on Microsoft remedies and pushed for tougher Internet privacy rules. It also took on the drug industry over costs.

•    Pension Rights Center. This center helped employees of IBM, General Electric, and other companies to organize themselves against cash-balance pension plans.

As we have noted above, some public activists and watchdog groups can exert a strong force on organizations and influence decisions that they may make. Strategy Spotlight 9.4 provides two examples of this phenomenon.

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 STRATEGY SPOTLIGHT

9.4   

TWO EXAMPLES OF POWERFUL EXTERNAL CONTROL MECHANISMS

McDonald’s

After years of fending off and ignoring critics, McDonald’s has begun working with them. In 1999, People for the Ethical Treatment of Animals (PETA) launched its “McCruelty” campaign asking the company to take steps to alleviate the suffering of animals killed for its restaurants. Since then, PETA has switched tactics and is cooperating with the burger chain to modernize the company’s animal welfare standards and make further improvements. Following pressure from PETA, McDonald’s used its influence to force egg suppliers to improve the living conditions of hens and cease debeaking them. PETA has publicly lauded the company for its efforts. Recently, McDonald’s also has required beef and pork processors to improve their handling of livestock prior to slaughter. The company conducts regular audits of the packing plants to determine whether the animals are being treated humanely and will suspend purchases from slaughterhouses that don’t meet the company’s standards. The company’s overall image appears to have improved. According to the global consulting firm Reputation Institute, McDonald’s overall global brand ranking has risen from 27th in 2007 to 14th in 2012.

Nike

In January 2009, 1,800 laborers lost their jobs in Honduras when two local factories that made shirts for the U.S. sports-apparel giant Nike suddenly closed their doors and did not pay workers the $2 million in severance and other unemployment benefits they were due by law. Following pressure from U.S. universities and student groups, Nike announced that it was setting up a $1.5 million “workers’ relief fund” to assist the workers. Nike also agreed to provide vocational training and finance health coverage for workers laid off by the two subcontractors.

The relief fund from Nike came after pressure by groups such as the Worker Rights Consortium, which informed Nike customers of the treatment of the workers. The Worker Rights Consortium also convinced scores of U.S. universities whose athletic programs and campus shops buy Nike shoes and clothes to threaten cancellation of those lucrative contracts unless Nike did something to address the plight of the Honduran workers. Another labor watchdog, United Students Against Sweatshops, staged demonstrations outside Nike shops while chanting “Just Pay It,” a play on Nike’s commercial slogan, “Just Do It.” The University of Wisconsin cancelled its licensing agreement with the company over the matter and other schools, including Cornell University and the University of Washington, indicated they were thinking of following suit. The agreement is the latest involving overseas apparel factories in which an image-conscious brand like Nike responded to campaigns led by college students, who often pressure universities to stand up to producers of college-logo apparel when workers’ rights are threatened.

Sources: Kiley, D. & Helm, B. 2009. The Great Trust Offensive. Bloomberg Businessweek, September 28: 38—42; Brasher, P. 2010. McDonald’s Orders Improvements in Treatment of Hens. abcnews.com , August 23: np; Glover, K. 2009. PETA vs. McDonald’s: The Nicest Way to Kill a Chicken. www.bnet.com . February 20: np; www.mccruelty.com ; Greenhouse, S. 2010. Pressured, Nike to Help Workers in Honduras. The New York Times, July 27: B1; Padgett, T. 2010. Just Pay It: Nike Creates Fund for Honduran Workers. www.time.com , July 27: np; and Bustillo, M. 2010. Nike to Pay Some $2 Million to Workers Fired by Subcontractors. www. online.wsj.com , July 26: np; and rankingthebrands.com .

Corporate Governance: An International Perspective

The topic of corporate governance has long been dominated by agency theory and based on the explicit assumption of the separation of ownership and control.116 The central conflicts are principal-agent conflicts between shareholders and management. However, such an underlying assumption seldom applies outside of the United States and the United Kingdom. This is particularly true in emerging economies and continental Europe. Here, there is often concentrated ownership, along with extensive family ownership and control, business group structures, and weak legal protection for minority shareholders. Serious conflicts tend to exist between two classes of principals: controlling shareholders and minority shareholders. Such conflicts can be called principal-principal (PP) conflicts, as opposed to principal-agent conflicts (see Exhibits 9.8 and 9.9).

principal-principal conflicts

conflicts between two classes of principals—controlling shareholders and minority shareholders—within the context of a corporate governance system.

Strong family control is one of the leading indicators of concentrated ownership. In East Asia (excluding China), approximately 57 percent of the corporations have board chairmen and CEOs from the controlling families. In continental Europe, this number is 68 percent. A very common practice is the appointment of family members as board chairmen, CEOs, and other top executives. This happens because the families are controlling (not

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necessarily majority) shareholders. In 2003, 30-year-old James Murdoch was appointed CEO of British Sky Broadcasting (BSkyB), Europe’s largest satellite broadcaster. There was very vocal resistance by minority shareholders. Why was he appointed in the first place? James’s father just happened to be Rupert Murdoch, who controlled 35 percent of BSkyB and chaired the board. Clearly, this is a case of a PP conflict.

EXHIBIT 9.8   Traditional Principal-Agent Conflicts versus Principal-Principal Conflicts: How They Differ along Dimensions

 

Principal-Agent Conflicts

Principal-Principal Conflicts

Goal Incongruence

Between shareholders and professional managers who own a relatively small portion of the firm’s equity.

Between controlling shareholders and minority shareholders.

Ownership Pattern

Dispersed—5%—20% is considered “concentrated ownership.”

Concentrated—Often greater than 50% of equity is controlled by controlling shareholders.

Manifestations

Strategies that benefit entrenched managers at the expense of shareholders in general (e.g., shirking, pet projects, excessive compensation, and empire building).

Strategies that benefit controlling shareholders at the expense of minority shareholders (e.g., minority shareholder expropriation, nepotism, and cronyism).

Institutional Protection of Minority Shareholders

Formal constraints (e.g., judicial reviews and courts) set an upper boundary on potential expropriation by majority shareholders. Informal norms generally adhere to shareholder wealth maximization.

Formal institutional protection is often lacking, corrupted, or un-enforced. Informal norms are typically in favor of the interests of controlling shareholders ahead of those of minority investors.

Source: Adapted from Young, M., Peng, M. W., Ahlstrom, D., & Bruton, G. 2002. Governing the Corporation in Emerging Economies: A Principal-Principal Perspective. Academy of Management Best Papers Proceedings, Denver.

EXHIBIT 9.9   Principal-Agent Conflicts and Principal-Principal Conflicts: A Diagram

Source: Young, M. N., Peng, M. W., Ahlstrom, D., Bruton, G. D., & Jiang, 2008. Principal–Principal Conflicts in Corporate Governance. Journal of Management Studies 45(1):196–220; and Peng, M. V. 2006. Global Strategy. Cincinnati: Thomson South-Western. We are very appreciative of the helpful comments of Mike Young of Hong Kong Baptist University and Mike Peng of the University of Texas at Dallas.

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In general, three conditions must be met for PP conflicts to occur:

•   A dominant owner or group of owners who have interests that are distinct from minority shareholders.

•   Motivation for the controlling shareholders to exercise their dominant positions to their advantage.

•   Few formal (such as legislation or regulatory bodies) or informal constraints that would discourage or prevent the controlling shareholders from exploiting their advantageous positions.

The result is often that family managers, who represent (or actually are) the controlling shareholders, engage in expropriation of minority shareholders, which is defined as activities that enrich the controlling shareholders at the expense of minority shareholders. What is their motive? After all, controlling shareholders have incentives to maintain firm value. But controlling shareholders may take actions that decrease aggregate firm performance if their personal gains from expropriation exceed their personal losses from their firm’s lowered performance.

expropriation of minority shareholders

activities that enrich the controlling shareholders at the expense of the minority shareholders.

Another ubiquitous feature of corporate life outside of the United States and United Kingdom are business groups such as the keiretsus of Japan and the chaebols of South Korea. This is particularly dominant in emerging economies. A business group is “a set of firms that, though legally independent, are bound together by a constellation of formal and informal ties and are accustomed to taking coordinated action.”117 Business groups are especially common in emerging economies, and they differ from other organizational forms in that they are communities of firms without clear boundaries.

business groups

a set of firms that, though legally independent, are bound together by a constellation of formal and informal ties and are accustomed to taking coordinated action.

Business groups have many advantages that can enhance the value of a firm. They often facilitate technology transfer or intergroup capital allocation that otherwise might be impossible because of inadequate institutional infrastructure such as excellent financial services firms. On the other hand, informal ties—such as cross-holdings, board interlocks, and coordinated actions—can often result in intragroup activities and transactions, often at very favorable terms to member firms. Expropriation can be legally done through related transactions, which can occur when controlling owners sell firm assets to another firm they own at below market prices or spin off the most profitable part of a public firm and merge it with another of their private firms.

ISSUE FOR DEBATE

CEO Pay: Appropriate Incentives or Always Dealing the CEO a Winning Hand

Alpha Natural Resources had its worst ever financial performance in 2011. The firm shut six mines, laid off over 1,500 workers, and saw its stock price drop by 66 percent. Still, the board of directors granted the firm’s CEO a $528,000 bonus on top of his over $6 million pay package, noting his “tremendous efforts” to improve worker safety. Stories like these leave commentators questioning if the game is stacked to ensure that CEOs receive high pay regardless of their firm’s performance.

Most large firms structure the pay packages of their top executives so that the CEO and other senior executives’ pay is tied to firm performance. A large part of their pay is

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stock-based. The value of the stock options they receive go up and down with the price of the firm’s stock. Their annual bonuses are conditional on meeting preset performance targets. However, boards often change the rules if the firm performs poorly. If the stock price drops, leaving the options held by the CEO “underwater” and worthless, they often reprice the options the CEO holds to a lower price, making them potentially much more valuable to the CEO if the stock price bounces back. As noted above, boards also often find reasons to grant bonuses to CEOs even if the firm underperforms.

At first blush, this suggests the boards of directors are ineffective and serve to meet the desires of the CEO. But there is a logical reason why boards reprice options and grant bonuses when firms perform poorly. Boards may reprice options or change the goals that justify bonuses as a means to protect CEOs from being harmed by events out of their control. For example, if a spike in fuel prices hurts the performance of an airline or a major hurricane results in a loss for an insurance firm, the boards of these firms may argue that underperformance isn’t the fault of the CEO and shouldn’t result in less pay.

However, critics of this practice argue that it’s wrong to protect CEOs from bad luck but not withhold benefits if the firm benefits from good luck. Boards rarely, if ever, raise the standards on CEO pay when the firm benefits from an unanticipated event. A study by researchers at Claremont Graduate School and Washington University found that executives lost less pay when their firms experienced bad luck than they gained when the firm experienced good luck. Additionally, critics point out that most workers, such as the 1500 who were laid off by Alpha, don’t receive the same protection from adverse events that the CEO did.

Discussion Questions

1.   Is it appropriate for firms to insulate their CEOs’ pay from bad luck?

2.   How can firms restructure pay to ensure that the CEOs also don’t benefit from good luck?

Sources: Mider, Z. & Green, J. 2012. Heads or tails, some CEOs win the pay game. Bloomberg Businessweek, October 8: 23; and Devers, C., McNamara, G., Wiseman, R., & Arrfelt, M. 2008. Moving closer to the action: Examining compensation design effects on firm risk. Organization Science, 19: 548–566.

Reflecting on Career Implications …

   Behavioral Control: What types of behavioral control does your organization employ? Do you find these behavioral controls helping or hindering you from doing a good job? Some individuals are comfortable with and even desire rules and procedures for everything. Others find that they inhibit creativity and stifle initiative. Evaluate your own level of comfort with the level of behavioral control and then assess the match between your own optimum level of control and the level and type of control used by your organization. If the gap is significant, you might want to consider other career opportunities.

   Setting Boundaries and Constraints: Your career success depends to a great extent on you monitoring and regulating your own behavior. Setting boundaries and constraints on yourself can help you focus on strategic priorities, generate short-term objectives and action plans, improve efficiency and effectiveness, and minimize improper conduct. Identify the boundaries and constraints you have placed on yourself and evaluate how each of those contributes to your personal growth and career development. If you do not have boundaries and constraints, consider developing them.

   Rewards and Incentives: Is your organization’s reward structure fair and equitable? On what criteria do you base your conclusions? How does the firm define outstanding performance and reward it? Are these financial or nonfinancial rewards? The absence of rewards that are seen as fair and equitable can result in the long-term erosion of morale, which may have long-term adverse career implications for you.

   Culture: Given your career goals, what type of organizational culture would provide the best work environment? How does your organization’s culture deviate from this concept? Does your organization have a strong and effective culture? In the long run, how likely are you to internalize the culture of your organization? If you believe that there is a strong misfit between your values and the organization’s culture, you may want to reconsider your relationship with the organization.

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summary

For firms to be successful, they must practice effective strategic control and corporate governance. Without such controls, the firm will not be able to achieve competitive advantages and outperform rivals in the marketplace. We began the chapter with the key role of informational control. We contrasted two types of control systems: what we termed “traditional” and “contemporary” information control systems. Whereas traditional control systems may have their place in placid, simple competitive environments, there are fewer of those in today’s economy. Instead, we advocated the contemporary approach wherein the internal and external environment are constantly monitored so that when surprises emerge, the firm can modify its strategies, goals, and objectives.

Behavioral controls are also a vital part of effective control systems. We argued that firms must develop the proper balance between culture, rewards and incentives, and boundaries and constraints. Where there are strong and positive cultures and rewards, employees tend to internalize the organization’s strategies and objectives. This permits a firm to spend fewer resources on monitoring behavior, and assures the firm that the efforts and initiatives of employees are more consistent with the overall objectives of the organization.

In the final section of this chapter, we addressed corporate governance, which can be defined as the relationship between various participants in determining the direction and performance of the corporation. The primary participants include shareholders, management (led by the chief executive officer), and the board of directors. We reviewed studies that indicated a consistent relationship between effective corporate governance and financial performance. There are also several internal and external control mechanisms that can serve to align managerial interests and shareholder interests. The internal mechanisms include a committed and involved board of directors, shareholder activism, and effective managerial incentives and rewards. The external mechanisms include the market for corporate control, banks and analysts, regulators, the media, and public activists. We also addressed corporate governance from both a United States and an international perspective.

SUMMARY REVIEW QUESTIONS

1.   Why are effective strategic control systems so important in today’s economy?

2.   What are the main advantages of “contemporary” control systems over “traditional” control systems? What are the main differences between these two systems?

3.   Why is it important to have a balance between the three elements of behavioral control—culture; rewards and incentives; and, boundaries?

4.   Discuss the relationship between types of organizations and their primary means of behavioral control.

5.   Boundaries become less important as a firm develops a strong culture and reward system. Explain.

6.   Why is it important to avoid a “one best way” mentality concerning control systems? What are the consequences of applying the same type of control system to all types of environments?

7.   What is the role of effective corporate governance in improving a firm’s performance? What are some of the key governance mechanisms that are used to ensure that managerial and shareholder interests are aligned?

8.   Define principal–principal (PP) conflicts. What are the implications for corporate governance?

key terms

strategic control

traditional approach to strategic control

informational control

behavioral control

organizational culture

reward system

boundaries and constraints

corporate governance

corporation

agency theory

board of directors

shareholder activism

external governance control mechanisms

market for corporate control

takeover constraint

principal-principal conflicts

expropriation of minority shareholders

business groups

experiential exercise

McDonald’s Corporation, the world’s largest fast-food restaurant chain, with 2012 revenues of $28 billion, has recently been on a “roll.” Its shareholder value rose by over 50% from May 2010 to May 2013. Using the Internet or library sources, evaluate the quality of the corporation in terms of management, the board of directors, and shareholder activism. Are the issues you list favorable or unfavorable for sound corporate governance?

application questions & exercises

1.   The problems of many firms may be attributed to a “traditional” control system that failed to continuously monitor the environment and make necessary changes in their strategy and objectives.

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What companies are you familiar with that responded appropriately (or inappropriately) to environmental change?

2.   How can a strong, positive culture enhance a firm’s competitive advantage? How can a weak, negative culture erode competitive advantages? Explain and provide examples.

3.   Use the Internet to research a firm that has an excellent culture and/or reward and incentive system. What are this firm’s main financial and nonfinancial benefits?

4.   Using the Internet, go to the website of a large, publicly held corporation in which you are interested. What evidence do you see of effective (or ineffective) corporate governance?

ethics questions

1.   Strong cultures can have powerful effects on employee behavior. How does this create inadvertent control mechanisms? That is, are strong cultures an ethical way to control behavior?

2.   Rules and regulations can help reduce unethical behavior in organizations. To be effective, however, what other systems, mechanisms, and processes are necessary?

references

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3.      For a unique perspective on governance, refer to: Carmeli, A. & Markman, G. D. 2011. Capture, governance, and resilience: Strategy implications from the history of Rome. Strategic Management Journal, 32(3):332–341.

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5.      Simons, R. 1995. Control in an age of empowerment. Harvard Business Review, 13: 80–88. This chapter draws on this source in the discussion of informational control.

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10.    This discussion of control systems draws upon Simons, op. cit.

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12.    For an interesting perspective on this issue and how a downturn in the economy can reduce the tendency toward “free agency” by managers and professionals, refer to Morris, B. 2001. White collar blues. Fortune, July 23: 98–110.

13.    For a colorful example of behavioral control in an organization, see: Beller, P. C. 2009. Activision’s unlikely hero. Forbes. February 2: 52–58.

14.    Ouchi, W. 1981. Theory Z. Reading, MA: Addison-Wesley; Deal, T. E. & Kennedy, A. A. 1982. Corporate cultures. Reading, MA: Addison- Wesley; Peters, T. J. & Waterman, R. H. 1982. In search of excellence. New York: Random House; Collins, J. 2001. Good to great. New York: HarperCollins.

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17.    For an insightful discussion of IKEA’s unique culture, see Kling, K. & Goteman, I. 2003. IKEA CEO Anders Dahlvig on international growth and IKEA’s unique corporate culture and brand identity. Academy of Management Executive, 11(1): 31–31.

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19.    A perspective on how antisocial behavior can erode a firm’s culture can be found in Robinson, S. L. & O’Leary-Kelly, A. M. 1998. Monkey see, monkey do: The influence of work groups on the antisocial behavior of employees. Academy of Management Journal, 41(6): 658–672.

20.    Benkler, Y. 2011. The unselfish gene. Harvard Business Review, 89(7): 76–85.

21.    An interesting perspective on organizational culture is in: Mehta, S. N. 2009. UnderArmour reboots. Fortune, February 2: 29–33.

22.    For insights on social pressure as a means for control, refer to: Goldstein, N. J. 2009. Harnessing social pressure. Harvard Business Review, 87(2): 25.

23.    Mitchell, R. 1989. Masters of innovation. BusinessWeek, April 10: 58–63.

24.    Sellers, P. 1993. Companies that serve you best. Fortune, May 31: 88.

25.    Southwest Airlines Culture Committee. 1993. Luv Lines (company publication), March–April: 17–18; for an interesting perspective on the “downside” of strong “cultlike” organizational cultures, refer to Arnott, D. A. 2000. Corporate cults. New York: AMACOM.

26.    Kerr, J. & Slocum, J. W., Jr. 1987. Managing corporate culture through reward systems. Academy of Management Executive, 1(2): 99–107.

27.    For a unique perspective on leader challenges in managing wealthy professionals, refer to Wetlaufer, S. 2000. Who wants to manage a millionaire? Harvard Business Review, 78(4): 53–60.

28.    Netessine, S. & Yakubovich, V. 2012. The darwinian workplace. Harvard Business Review, 90(5): 25–28.

29.    For a discussion of the benefits of stock options as executive compensation, refer to Hall, B. J. 2000. What you need to know about stock options. Harvard Business Review, 78(2): 121–129.

30.    Tully, S. 1993. Your paycheck gets exciting. Fortune, November 13: 89.

31.    Carter, N. M. & Silva, C. 2010. Why men still get more promotions than women. Harvard Business Review, 88(9): 80–86.

32.    Zellner, W., Hof, R. D., Brandt, R., Baker, S., & Greising, D. 1995. Go-go goliaths. BusinessWeek, February 13: 64–70.

33.    Birkinshaw, J., Bouquet, C., & Barsoux, J. 2011. The 5 myths of innovation. MIT Sloan Management Review, Winter: 43–50.

34.    Bryant, A. 2011. The corner office. New York: St. Martin’s Griffin: 173.

35.    This section draws on Dess & Picken, op. cit.: chap. 5.

36.    Anonymous. 2012. Nestle set to buy Pfizer unit. Dallas Morning News, April 19: 10D.

37.    Isaacson, W. 2012. The real leadership lessons of Steve Jobs. Harvard Business Review, 90(4): 93–101.

38.    This section draws upon Dess, G. G. & Miller, A. 1993. Strategic management. New York: McGraw-Hill.

39.    For a good review of the goal-setting literature, refer to Locke, E. A. & Latham, G. P. 1990. A theory of goal setting and task performance. Englewood Cliffs, NJ: Prentice Hall.

40.    For an interesting perspective on the use of rules and regulations that is counter to this industry’s (software) norms, refer to Fryer, B. 2001. Tom Siebel of Siebel Systems: High tech the old fashioned way. Harvard Business Review, 79(3): 118–130.

41.    Thompson, A. A. Jr. & Strickland, A. J., III. 1998. Strategic management: Concepts and cases (10th ed.): 313. New York: McGraw-Hill.

42.    Ibid.

43.    Teitelbaum, R. 1997. Tough guys finish first. Fortune, July 21: 82–84.

44.    Weaver, G. R., Trevino, L. K., & Cochran, P. L. 1999. Corporate ethics programs as control systems: Influences of executive commitment and environmental factors. Academy of Management Journal, 42(1): 41–57.

45.    www.singaporeair.com/pdf/media-centre/anti-corruption-policy-procedures.pdf.

46.    Weber, J. 2003. CFOs on the hot seat. BusinessWeek, March 17: 66–70.

47.    William Ouchi has written extensively about the use of clan control (which is viewed as an alternate to bureaucratic or market control). Here, a powerful culture results in people aligning their individual interests with those of the firm. Refer to Ouchi, op. cit. This section also draws on Hall, R. H. 2002. Organizations: Structures, processes, and outcomes (8th ed.). Upper Saddle River, NJ: Prentice Hall.

48.    Poundstone, W. 2003. How would you move Mount Fuji? New York: Little, Brown: 59.

49.    Abby, E. 2012. Woman sues over personality test job rejection. abcnews.go.com , October 1: np.

50.    Interesting insights on corporate governance are in: Kroll, M., Walters, B. A., & Wright, P. 2008. Board vigilance, director experience, and corporate outcomes. Strategic Management Journal, 29(4): 363–382.

51.    For a brief review of some central issues in corporate governance research, see: Hambrick, D. C., Werder, A. V., & Zajac, E. J. 2008. New directions in corporate governance research. Organization Science, 19(3): 381–385.

52.    Monks, R. & Minow, N. 2001. Corporate governance (2nd ed.). Malden, MA: Blackwell.

53.    Pound, J. 1995. The promise of the governed corporation. Harvard Business Review, 73(2): 89–98.

54.    Maurer, H. & Linblad, C. 2009. Scandal at Satyam. BusinessWeek, January 19: 8; Scheck, J. & Stecklow, S. 2008. Brocade ex-CEO gets 21 months in prison. The Wall Street Journal, January 17: A3; Levine, D. & Graybow, M. 2010. Mozilo to pay millions in Countrywide settlement. finance. yahoo.com . October 15: np; Ellis, B. 2010. Countrywide’s Mozilo to pay $67.5 million settlement. cnnmoney.com . October 15: np; Frank, R., Efrati, A., Lucchetti, A. & Bray, C. 2009. Madoff jailed after admitting epic scam. The Wall Street Journal. March 13: A1; and Henriques, D. B. 2009. Madoff is sentenced to 150 years for Ponzi scheme. www.nytimes.com . June 29: np.

55.    Anonymous. 2012. Olympus and ex-executives plead guilty in accounting fraud. nytimes.com , September 25: np.

56.    Corporate governance and social networks are discussed in: McDonald, M. L., Khanna, P., & Westphal, J. D. 2008. Academy of Management Journal. 51(3): 453–475.

57.    This discussion draws upon Monks & Minow, op. cit.

58.    For an interesting perspective on the politicization of the corporation, read: Palazzo, G. & Scherer, A. G. 2008. Corporate social responsibility, democracy, and the politicization of the corporation. Academy of Management Review, 33(3): 773–774.

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59.    Eisenhardt, K. M. 1989. Agency theory: An assessment and review. Academy of Management Review, 14(1): 57–74. Some of the seminal contributions to agency theory include Jensen, M. & Meckling, W. 1976. Theory of the firm: Managerial behavior, agency costs, and ownership structure. Journal of Financial Economics, 3: 305–360; Fama, E. & Jensen, M. 1983. Separation of ownership and control. Journal of Law and Economics, 26: 301, 325; and Fama, E. 1980. Agency problems and the theory of the firm. Journal of Political Economy, 88: 288–307.

60.    Nyberg, A. J., Fulmer, I. S., Gerhart, B. & Carpenter, M. 2010. Agency theory revisited: CEO return and shareholder interest alignment. Academy of Management Journal, 53(5): 1029–1049.

61.    Managers may also engage in “ shirking”—that is, reducing or withholding their efforts. See, for example, Kidwell, R. E., Jr. & Bennett, N. 1993. Employee propensity to withhold effort: A conceptual model to intersect three avenues of research. Academy of Management Review, 18(3): 429–456.

62.    For an interesting perspective on agency and clarification of many related concepts and terms, visit www.encycogov.com .

63.    The relationship between corporate ownership structure and export intensity in Chinese firms is discussed in: Filatotchev, I., Stephan, J., & Jindra, B. 2008. Ownership structure, strategic controls and export intensity of foreign-invested firms in transition economies. Journal of International Business, 39(7): 1133–1148.

64.    Argawal, A. & Mandelker, G. 1987. Managerial incentives and corporate investment and financing decisions. Journal of Finance, 42: 823–837.

65.    Gross. D. 2012. Outrageous CEO compensation: Wynn, Adelson, Dell and Abercrombie shockers. finance.yahoo.com , June 7: np.

66.    Anonymous. 2013. Too early for the worst footnote of 2013? footnoted.com , January 18: np.

67.    For an insightful, recent discussion of the academic research on corporate governance, and in particular the role of boards of directors, refer to Chatterjee, S. & Harrison, J. S. 2001. Corporate governance. In Hitt, M. A., Freeman, R. E., & Harrison, J. S. (Eds.). Handbook of strategic management: 543–563. Malden, MA: Blackwell.

68.    For an interesting theoretical discussion on corporate governance in Russia, see: McCarthy, D. J. & Puffer, S. M. 2008. Interpreting the ethicality of corporate governance decisions in Russia: Utilizing integrative social contracts theory to evaluate the relevance of agency theory norms. Academy of Management Review, 33(1): 11–31.

69.    Haynes, K. T. & Hillman, A. 2010. The effect of board capital and CEO power on strategic change. Strategic Management Journal, 31(110): 1145–1163.

70.    This opening discussion draws on Monks & Minow, op. cit. 164, 169; see also Pound, op. cit.

71.    Business Roundtable. 1990. Corporate governance and American competitiveness, March: 7.

72.    The director role in acquisition performance is addressed in: Westphal, J. D. & Graebner, M. E. 2008. What do they know? The effects of outside director acquisition experience on firm acquisition performance. Strategic Management Journal, 29(11): 1155–1178.

73.    Byrne, J. A., Grover, R., & Melcher, R. A. 1997. The best and worst boards. BusinessWeek, November 26: 35–47. The three key roles of boards of directors are monitoring the actions of executives, providing advice, and providing links to the external environment to provide resources. See Johnson, J. L., Daily, C. M., & Ellstrand, A. E. 1996. Boards of directors: A review and research agenda. Academy of Management Review, 37: 409–438.

74.    Pozen, R. C. 2010. The case for professional boards. Harvard Business Review, 88(12): 50–58.

75.    The role of outside directors is discussed in: Lester, R. H., Hillman, A., Zardkoohi, A., & Cannella, A. A. Jr. 2008. Former government officials as outside directors: The role of human and social capital. Academy of Management Journal, 51(5): 999–1013.

76.    McGeehan, P. 2003. More chief executives shown the door, study says. New York Times, May 12: C2.

77.    The examples in this paragraph draw upon Helyar, J. & Hymowitz, C. 2011. The recession is gone, and the CEO could be next. Bloomberg Businessweek. Februrary 7-February 13: 24–26; Stelter, B. 2010. Jonathan Klein to leave CNN. mediadecoder.blogs.nytimes.com . September 24: np; Silver, A. 2010. Milestones. TIME Magazine. December 20: 28; www.bp.com and Mouawad, J. & Krauss, C. 2010. BP is expected to replace Hayward as chief with American. The New York Times. July 26: A1.

78.    Stoever, H. 2012. NACD highlights growing need for succession planning and diversity in the boardroom. nacdonline.org , March 22: np.

79.    For an analysis of the effects of outside directors’ compensation on acquisition decisions, refer to Deutsch, T., Keil, T., & Laamanen, T. 2007. Decision making in acquisitions: The effect of outside directors’ compensation on acquisition patterns. Journal of Management, 33(1): 30–56.

80.    Director interlocks are addressed in: Kang, E. 2008. Director interlocks and spillover effects of reputational penalties from financial reporting fraud. Academy of Management Journal, 51(3): 537–556.

81.    There are benefits, of course, to having some insiders on the board of directors. Inside directors would be more aware of the firm’s strategies. Additionally, outsiders may rely too often on financial performance indicators because of information asymmetries. For an interesting discussion, see Baysinger, B. D. & Hoskisson, R. E. 1990. The composition of boards of directors and strategic control: Effects on corporate strategy. Academy of Management Review, 15: 72–87.

82.    Hambrick, D. C. & Jackson, E. M. 2000. Outside directors with a stake: The linchpin in improving governance. California Management Review, 42(4): 108–127.

83.    Corsi, C, Dale, G., Daum, J, Mumm, J, & Schoppen, W. 2010. 5 things board directors should be thinking about. spencerstuart.com , December: np; Evans, B. 2007. Six steps to building an effective board. Inc.com , np; Beatty, D. 2009. New challenges for corporate governance. Rotman Magazine, Fall: 58–63; and Krause, R., Semadeni, M., & Cannella, A. 2013. External COO/presidents as expert directors: A new look at the service role of boards. Strategic Management Journal. In press.

84.    A discussion on the shareholder approval process in executive compensation is presented in: Brandes, P., Goranova, M., & Hall, S. 2008. Navigating shareholder influence: Compensation plans and the shareholder approval process. Academy of Management Perspectives, 22(1): 41–57.

85.    Monks and Minow, op. cit.: 93.

86.    A discussion of the factors that lead to shareholder activism is found in Ryan, L. V. & Schneider, M. 2002. The antecedents of institutional investor activism. Academy of Management Review, 27(4): 554–573.

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87.    For an insightful discussion of investor activism, refer to David, P., Bloom, M., & Hillman, A. 2007. Investor activism, managerial responsiveness, and corporate social performance. Strategic Management Journal, 28(1): 91–100.

88.    There is strong research support for the idea that the presence of large block shareholders is associated with value-maximizing decisions. For example, refer to Johnson, R. A., Hoskisson, R. E., & Hitt, M. A. 1993. Board of director involvement in restructuring: The effects of board versus managerial controls and characteristics. Strategic Management Journal, 14: 33–50.

89.    For a discussion of institutional activism and its link to CEO compensation, refer to: Chowdhury, S. D. & Wang, E. Z. 2009. Institutional activism types and CEO compensation. Journal of Management, 35(1): 5–36.

90.    For an interesting perspective on the impact of institutional ownership on a firm’s innovation strategies, see Hoskisson, R. E., Hitt, M. A., Johnson, R. A., & Grossman, W. 2002. Academy of Management Journal, 45(4): 697–716.

91.     www.calpers-governance.org .

92.    Icahn, C. 2007. Icahn: On activist investors and private equity run wild. BusinessWeek, March 12: 21–22. For an interesting perspective on Carl Icahn’s transition (?) from corporate raider to shareholder activist, read Grover, R. 2007. Just don’t call him a raider. BusinessWeek, March 5: 68–69. The quote in the text is part of Icahn’s response to the article by R. Grover.

93.    Bond, P. 2012. Netflix stock climbs after Carl Icahn takes a position. hollywoodreporter.com , October 31: np.

94.    For a study of the relationship between ownership and diversification, refer to Goranova, M., Alessandri, T. M., Brandes, P., & Dharwadkar, R. 2007. Managerial ownership and corporate diversification: A longitudinal view, Strategic Management Journal, 28(3): 211–226.

95.    Jensen, M. C. & Murphy, K. J. 1990. CEO incentives—It’s not how much you pay, but how. Harvard Business Review, 68(3): 138–149.

96.    For a perspective on the relative advantages and disadvantages of “duality”—that is, one individual serving as both Chief Executive Office and Chairman of the Board, see Lorsch, J. W. & Zelleke, A. 2005. Should the CEO be the chairman? MIT Sloan Management Review, 46(2): 71–74.

97.    A discussion of knowledge sharing is addressed in: Fey, C. F. & Furu, P. 2008. Top management incentive compensation and knowledge sharing in multinational corporations. Strategic Management Journal, 29(12): 1301–1324.

98.    Sasseen, J. 2007. A better look at the boss’s pay. BusinessWeek, February 26: 44–15; and Weinberg, N., Maiello, M., & Randall, D. 2008. Paying for failure. Forbes, May 19: 114, 116.

99.    Research has found that executive compensation is more closely aligned with firm performance in companies with compensation committees and boards dominated by outside directors. See, for example, Conyon, M. J. & Peck, S. I. 1998. Board control, remuneration committees, and top management compensation. Academy of Management Journal, 41: 146–157.

100.  Anonymous. 2012. American chief executives are not overpaid. The Economist, September 8: 67.

101.  Caldwell, D. & Francolla, G. 2012. Highest paid CEOs. cnbc.com , November 19: np.

102.  George, B. 2010. Executive pay: Rebuilding trust in an era of rage. Bloomberg Businessweek, September 13: 56.

103.  Chahine, S. & Tohme, N. S. 2009. Is CEO duality always negative? An exploration of CEO duality and ownership structure in the Arab IPO context. Corporate Governance: An International Review. 17(2): 123–141; and McGrath, J. 2009. How CEOs work. HowStuffWorks. com. January 28: np.

104.  Anonymous. 2009. Someone to watch over them. The Economist. October 17: 78; Anonymous. 2004. Splitting up the roles of CEO and Chairman: Reform or red herring? Knowledge@Wharton . June 2: np; and Kim, J. 2010. Shareholders reject split of CEO and chairman jobs at JPMorgan. FierceFinance.com . May 18: np.

105.  Tuggle, C. S., Sirmon, D. G., Reutzel, C. R. & Bierman, L. 2010. Commanding board of director attention: Investigating how organizational performance and CEO duality affect board members’ attention to monitoring. Strategic Management Journal. 31: 946–968; Weinberg, N. 2010. No more lapdogs. Forbes. May 10: 34–36; and Anonymous. 2010. Corporate constitutions. The Economist. October 30: 74.

106.  Semadeni, M. & Krause, R. 2012. Splitting the CEO and chairman roles: It’s complicated … businessweek.com , November 1: np.

107.  Such opportunistic behavior is common in all principal-agent relationships. For a description of agency problems, especially in the context of the relationship between shareholders and managers, see Jensen, M. C. & Meckling, W. H. 1976. Theory of the firm: Managerial behavior, agency costs, and ownership structure. Journal of Financial Economics, 3: 305–360.

108.  Hoskisson, R. E. & Turk, T. A. 1990. Corporate restructuring: Governance and control limits of the internal market. Academy of Management Review, 15: 459–477.

109.  For an insightful perspective on the market for corporate control and how it is influenced by knowledge intensity, see Coff, R. 2003. Bidding wars over R&D-intensive firms: Knowledge, opportunism, and the market for corporate control. Academy of Management Journal, 46(1): 74–85.

110.  Walsh, J. P. & Kosnik, R. D. 1993. Corporate raiders and their disciplinary role in the market for corporate control. Academy of Management Journal, 36: 671–700.

111.  The role of regulatory bodies in the banking industry is addressed in: Bhide, A. 2009. Why bankers got so reckless. BusinessWeek, February 9: 30–31.

112.  Wishy-washy: The SEC pulls its punches on corporate-governance rules. 2003. Economist, February 1: 60.

113.  McLean, B. 2001. Is Enron overpriced? Fortune, March 5: 122–125.

114.  Swartz, J. 2010. Timberland’s CEO on standing up to 65,000 angry activists. Harvard Business Review, 88 (9): 39–43.

115.  Bernstein, A. 2000. Too much corporate power. BusinessWeek, September 11: 35–37.

116.  This section draws upon Young, M. N., Peng, M. W., Ahlstrom, D., Bruton, G. D., & Jiang, Y. 2005. Principal-principal conflicts in corporate governance (un-published manuscript); and, Peng, M. W. 2006. Globalstrategy. Cincinnati: Thomson South-Western. We appreciate the helpful comments of Mike Young of Hong Kong Baptist University and Mike Peng of the University of Texas at Dallas.

117.  Khanna, T. & Rivkin, J. 2001. Estimating the performance effects of business groups in emerging markets. Strategic Management Journal, 22: 45–74.

10

Creating Effective
Organizational Designs

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10 - *

Learning Objectives

  • After reading this chapter, you should have a good understanding of:
  • The importance of organizational structure and the concept of the “boundaryless” organization in implementing strategies.
  • The growth patterns of major corporations and the relationship between a firm’s strategy and its structure.
  • Each of the traditional types of organizational structure: simple, functional, divisional, and matrix
  • The relative advantages and disadvantages of traditional organizational structure
  • The implications of a firm’s international operations for organizational structure

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Learning Objectives

  • After reading this chapter, you should have a good understanding of:
  • Why there is no “one best way” to design strategic reward and evaluation systems, and the important contingent roles of business- and corporate-level strategies.
  • The different types of boundaryless organizations—barrier-free, modular, and virtual—and their relative advantages and disadvantages
  • The need for creating ambidextrous organizational designs that enable firms to explore new opportunities and effectively integrate existing operations

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Traditional Forms of
Organizational Structure

  • Organizational structure refers to formalized patterns of interactions that link a firm’s
  • Tasks
  • Technologies
  • People
  • Structure provides a means of balancing two conflicting forces
  • Need for the division of tasks into meaningful groupings
  • Need to integrate the groupings for efficiency and effectiveness

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Question

Most organizations begin very small and ______.

A) grow to become a medium sized organization

B) continually grow

C) remain small

D) often decrease in size

*

Answer: C

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Dominant Growth Patterns
of Large Corporations

Adapted from Exhibit 10.1 Dominant Growth Patterns of Large Corporations

Source: Adapted from J. R. Galbraith and R. K. Kazanjian, Strategy Implementation: The Role of Structure and Process, 2nd ed. (St. Paul, MN: West Publishing Company, 1986), p. 139.

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Patterns of Growth of
Large Corporations

  • Simple Structure
  • Simple structure is the oldest and most common organizational form
  • Staff serve as an extension of the top executive’s personality
  • Highly informal
  • Coordination of tasks by direct supervision
  • Decision making is highly centralized
  • Little specialization of tasks, few rules and regulations, informal evaluation and reward system

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Patterns of Growth of
Large Corporations

  • Functional Structure

Adapted from Exhibit 10.2 Functional Organizational Structure

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Patterns of Growth
of Large Corporations

  • Functional Structure
  • Found where there is a single or closely related product or service, high production volume, and some vertical integration
  • Advantages
  • Enhanced coordination and control
  • Centralized decision making
  • Enhanced organizational-level perspective
  • More efficient use of managerial and technical talent
  • Facilitated career paths and development in specialized areas

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Patterns of Growth
of Large Corporations

  • Disadvantages
  • Impeded communication and coordination due to differences in values and orientations
  • May lead to short-term thinking (functions vs. organization as a whole)
  • Difficult to establish uniform performance standards

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Divisional Structure

Adapted from Exhibit 10.3 Divisional Organizational Structure

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Divisional Structure

  • Organized around products, projects, or markets
  • Each division includes its own functional specialists typically organized into departments
  • Divisions are relatively autonomous and consist of products and services that are different from those of other divisions
  • Division executives help determine product-market and financial objectives

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Divisional Structure

  • Advantages
  • Strategic business unit (SBU) structure
  • Separation of strategic and operating control
  • Quick response to important changes in external environment
  • Minimal problems of sharing resources across functional departments
  • Development of general management talent is enhanced

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Divisional Structure

  • Disadvantages
  • Can be very expensive
  • Can be dysfunctional competition among divisions
  • Can be a sense of a “zero-sum” game that discourages sharing ideas and resources among divisions
  • Differences in image and quality may occur across divisions
  • Can focus on short-term performance

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Divisional Structure

  • Strategic business unit (SBU) structure
  • Divisions with similar products, markets, and/or technologies are grouped into homogenous SBUs
  • Task of planning and control at corporate office is more manageable
  • May become difficult to achieve synergies across SBUs
  • Appropriate when the businesses in a corporation’s portfolio do not have much in common
  • Lower expenses and overhead, fewer levels in the hierarchy
  • Inherent lack of control and dependence of CEO-level executives on divisional executives

*

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Matrix Structure

Adapted from Exhibit 10.4 Matrix Organizational Structure

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Matrix Structure

  • A combination of the functional and divisional structures
  • Individuals who work in a matrix organization become responsible to two managers
  • The project manager
  • The functional area manager

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Matrix Structure

  • Advantages
  • Facilitates the use of specialized personnel, equipment and facilities
  • Provides professionals with a broader range of responsibility and experience
  • Disadvantages
  • Can cause uncertainty and lead to intense power struggles
  • Working relationships become more complicated
  • Decisions may take longer

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International Operations: Implications for Organizational Structure

  • Three major contingencies influence structure adopted by firms with international operations
  • Type of strategy driving the firm’s foreign operations
  • Product diversity
  • Extent to which the firm is dependent on foreign sales
  • Structures used to manage international operations
  • International division
  • Geographic-area division
  • Worldwide functional
  • Worldwide product division
  • Worldwide matrix

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Example

  • Nike culture used to encourage local managers to focus on market share rather than profitability.
  • This lead to Wall Street to comment on the lack of managerial control at Nike.
  • Nike decided to implement a matrix structure to resolve this issue.
  • This matrix structure clearly stated local managers’ responsibilities by region and product.
  • Nike headquarters establishes which products to focus on and how to do it under the new matrix structure.

Source: “The New Nike,” Business Week. September 20, 2004

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Question

Does the relationship between strategy and structure imply that structure follows strategy?

*

The strategy of a firm influences their structural elements as the division of tasks. It is also true that existing structures can influence the formulation of strategies of a firm. Ultimately, strategy cannot be developed without the consideration of a firm’s structural elements.

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Relationships between Rewards & Evaluation Systems and Business-level and Corporate-level Strategies

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Boundaryless Organizational Designs

  • Boundaries that place limits on organizations
  • Vertical boundaries between levels in the organization’s hierarchy
  • Horizontal boundaries between functional areas
  • External boundaries between the firm and its customers, suppliers, and regulators
  • Geographic boundaries between locations, cultures and markets

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Making Boundaries More Permeable

  • First approach
  • Permeable internal boundaries
  • Higher level of trust and shared interests
  • Shift in philosophy from executive development of organizational development
  • Greater use of teams
  • Flexible, porous organizational boundaries
  • Communication flows and mutually beneficial relationships with internal and external constituencies

Barrier-free type of organization

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Pros and Cons of
Barrier-Free Structures

Adapted from Exhibit 10.7 Pros and Cons of Barrier-Free Structures

*

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Making Boundaries More Permeable

  • Second approach
  • Outsources nonvital functions, tapping

into knowledge and expertise of “best in class” suppliers but retains strategic control

  • Three advantages
  • Decrease overall costs, leverage capital
  • Enables company to focus scarce resources on areas where it holds competitive advantage
  • Adds critical skills and accelerates organizational learning

Modular type of organization

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Pros and Cons of Modular Structures

Adapted from Exhibit 10.8 Pros and Cons of Modular Structures

*

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Making Boundaries More Permeable

  • Third approach
  • Continually evolving network of

independent companies linked together to share skills, costs, and access to one another’s markets

  • Suppliers
  • Customers
  • Competitors
  • Each gains from resulting individual and organizational learning
  • May not be permanent

Virtual type of organization

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Pros and Cons of Virtual Structures

Source: R. E. Miles and C. C. Snow, “Organizations: New Concepts for New Forms,” California Management Review,” Spring 1986, pp. 62-73; R. E. Miles and C. C. Snow, “Causes of Failure in Network Organizations,” California Management Review, Summer 1999, pp. 53-72; and H. Bahrami, “The Emerging Flexible Organization: Perspectives from Silicon Valley,” California Management Review, Summer 1991, pp. 33-52.

Adapted from Exhibit 10.9 Pros and Cons of Virtual Structures

*

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Boundaryless Organizations:
Making Them Work

  • Factors facilitating effective coordination and integration of key activities
  • Common culture and shared values
  • Horizontal organization structures
  • Horizontal systems and processes
  • Communications and information technologies
  • Human resource practices

*

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Creating Ambidextrous
Organizational Designs

  • Two contradictory challenges faced by firms
  • Adaptability
  • Alignment
  • Ambidextrous organizations
  • Aligned and efficient in how they manage in today’s business
  • Flexible enough to changes in the environment so they will prosper tomorrow

*

10

Creating Effective
Organizational Designs

*

9

Strategic Control and
Corporate Governance

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9 - *

Learning Objectives

  • After reading this chapter, you should have a good understanding of:
  • The value of effective strategic control systems in strategy implementation.
  • The key difference between “traditional” and “contemporary” control systems.
  • The imperative for “contemporary” control systems in today’s complex and rapidly changing competitive and general environments.
  • The benefits of having the proper balance among the three levers of behavioral control: culture, rewards and incentives, and boundaries.
  • The three key participants in corporate governance: shareholders, management (led by the CEO), and the board of directors.
  • The role of corporate governance mechanisms in ensuring that the interests of managers are aligned with those of shareholders from both the United States and international perspectives.

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Ensuring Informational Control

  • Traditional control system
  • Based largely on the feedback approach
  • Little or no action taken to revise strategies, goals and objectives until the end of the time period
  • Contemporary control system
  • Continually monitoring the environments (internal and external)
  • Identifying trends and events that signal the need to revise strategies, goals and objectives

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Traditional Approach to
Strategic Control

  • Traditional approach is sequential
  • Strategies are formulated and top management sets goals
  • Strategies are implemented
  • Performance is measured against the predetermined goal set
  • Control is based on a feedback loop from performance measurement to strategy formulation

Adapted from Exhibit 9.1 Traditional Approach to Strategic Control

*

9 - *

Traditional Approach
to Strategic Control

  • Process typically involves lengthy time lags, often tied to the annual planning cycle
  • This “single-loop” learning control system simply compares actual performance to a predetermined goal
  • Most appropriate when
  • Environment is stable and relatively simple
  • Goals and objectives can be measured with certainty
  • Little need for complex measures of performance

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9 - *

Contemporary Approach
to Strategic Control

  • Relationships between strategy formulation, implementation and control are highly interactive
  • Two different types of control
  • Informational control
  • Behavioral control

Adapted from Exhibit 9.2 Contemporary Approach to Strategic Control

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9 - *

  • Informational control
  • Concerned with whether or not the organization is “doing the right things”
  • Behavioral control
  • Concerned with whether or not the organization is “doing things right” in the implementation of its strategy
  • Both types of control are necessary conditions for success

Contemporary Approach
to Strategic Control

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Informational Control

  • Deals with internal environment and external strategic context
  • Key question
  • “Do the organization’s goals and strategies still ‘fit’ within the context of the current strategic environment?”
  • Two key issues
  • Scan and monitor external environment (general and industry)
  • Continuously monitor the internal environment

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Informational Control

  • Traditional approach
  • Understanding of the assumption base is an initial step in the process of strategy formulation
  • Contemporary approach
  • Information control is part of an ongoing process of organizational learning that updates and challenges the assumptions underlying the firm’s strategy

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Informational Control

Continuously

  • Monitor
  • Test
  • Review

Update and Challenge the assumptions

The Firm’s

Contemporary Control System

Assumptions

Premises

Goals

Strategies

9 - *

Question

What are two compelling reasons for an increased emphasis on culture and rewards in implementing a system of behavioral control?

*

First, organizations are facing competition that continually becomes increasingly more complex. Organizations must be flexible and act quickly to respond to challenges that arise in an uncertain environment.

Second, the implicit contract between an organization and their key employees has decomposed over the years because younger managers view themselves as free agents in today’s labor market.

9 - *

Behavioral Control

  • Behavioral control is focused on implementation—doing things right
  • Three key control “levers”
  • Culture
  • Rewards
  • Boundaries

*

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Behavioral Control: Balancing Culture,
Rewards, and Boundaries

  • Contemporary approach

- A balance between

  • Culture
  • Rewards
  • Boundaries
  • Traditional approach
  • Emphasizes comparing outcomes to predetermined strategies and fixed rules

Adapted from Exhibit 9.3 Essential Elements of Strategic Control

*

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Building a Strong and Effective Culture

  • Organizational culture is a system of
  • Shared values (what is important)
  • Beliefs (how things work)
  • Organizational culture shapes a firm’s
  • People
  • Organizational structures
  • Control systems
  • Organizational culture produces
  • Behavioral norms (the way we do things around here)

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Building a Strong and Effective Culture

  • Culture sets implicit boundaries (unwritten standards of acceptable behavior)
  • Dress
  • Ethical matters
  • The way an organization conducts its business
  • Culture acts as a means of reducing monitoring costs

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Example

  • Many researchers are breaking the rules according to Raymond De Vries, an associate professor of medical education and a member of the Bioethics Program at the University of Michigan in Ann Arbor.
  • Numerous researchers are falsifying their research to compete with the intense competition within the field of science.
  • The organizational culture of a company, not an individual’s failing character, is the underlining cause for unethical behavior of researchers.

Source:. “Many Researchers Break the Rules: Study,,” Forbes. April 13, 2006.

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Building a Strong and Effective Culture

  • Effective culture must be
  • Cultivated
  • Encouraged
  • Fertilized
  • Maintaining an effective culture
  • Storytelling
  • Rallies or pep talks by top executives

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Motivating with Rewards and Incentives

  • Rewards and incentive systems
  • Powerful means of influencing an organization’s culture
  • Focuses efforts on high-priority tasks
  • Motivates individual and collective task performance
  • Can be an effective motivator and control mechanism

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Motivating with Rewards and Incentives

  • Potential downside
  • Subcultures may arise in different business units with multiple reward systems
  • May reflect differences among functional areas, products, services and divisions
  • Shared values may emerge in subculture in opposition to patterns of the dominant culture
  • Reward systems may lead to information hoarding, working at cross purposes

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Motivating with Rewards and Incentives

  • Creating effective reward and incentive programs
  • Objectives are clear, well understood and broadly accepted
  • Rewards are clearly linked to performance and desired behaviors
  • Performance measures are clear and highly visible
  • Feedback is prompt, clear, and unambiguous
  • Compensation “system” is perceived as fair and equitable
  • Structure is flexible; it can adapt to changing circumstances

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Setting Boundaries and Constraints

  • Focus efforts on strategic priorities
  • Short-term objectives
  • Specific and measurable
  • Specific time horizon for attainment
  • Achievable, but challenging
  • Provide proper direction, but be flexible when faced with need to change

*

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Setting Boundaries and Constraints

  • Short-term action plans
  • Specific
  • Can be implemented
  • Individual managers held accountable for implementation of action plans

*

9 - *

Question

Which of the following types of controls is most appropriate in an organization where consistency in product and service is critical?

A) Bureaucratic controls

B) Systematic controls

C) Cultural controls

D) Rule-based controls

*

Answer: D

9 - *

Organizational Control:
Alternative Approaches

Approach Some Situational Factors

Culture: a system of unwritten rules that forms an internalized influence over behavior.

Rules: Written and explicit guidelines that provide external constraints on behavior.

  • Often found in professional organizations
  • Associated with high autonomy
  • Norms are the basis for behavior
  • Associated with standardized output
  • Tasks are generally repetitive

and routine

  • Little need for innovation or creative activity

Adapted from Exhibit 9.6 Organizational Control: Alternative Approaches

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Approach Some Situational Factors

Rewards: The use of performance-based incentive systems to motivate.

Organizational Control:
Alternative Approaches

  • Measurement of output and performance is rather straightforward
  • Most appropriate in organizations pursuing unrelated diversification strategies
  • Rewards may be used to reinforce other means of control

Adapted from Exhibit 9.6 Organizational Control: Alternative Approaches

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Evolving from Boundaries
to Rewards and Culture

  • Organizations should strive to have boundaries internalized
  • System of rewards and incentives coupled with a strong culture
  • Hire the right people (already identify with the firm’s dominant values)
  • Train people in the dominant cultural values
  • Have managerial role models
  • Reward systems clearly aligned with organizational goals and objectives

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Role of Corporate Governance

  • Corporate governance
  • Relationship among
  • The shareholders
  • The management (led by the Chief Executive Officer)
  • The board of directors
  • Issue is
  • How corporations can succeed (or fail) in aligning managerial motives with
  • The interests of the shareholders
  • The interests of the board of directors

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Example

  • Stock-option stashes grew 47% from the previous year for CEO’s according to compensation consulting firm Watson Wyatt.
  • Soaring stock-option growth indicates that CEOs pay is directly related to their good performance.
  • Watson Wyatt believes the compensation package offered to CEO’s is in accordance with the job market.
  • If the board of a company could hire someone to do the job for less, they would hire that individual.

Source: Clark, Hannah. “Stock-Option Stashes for CEOs,” Forbes, February 28, 2007.

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Separation of Owners (Shareholders)
and Management

  • Shareholders (investors)
  • Limited liability
  • Participate in the profits of the enterprise
  • Limited involvement in the company’s affairs
  • Management
  • Run the company
  • Does not personally have to provide the funds
  • Board of directors
  • Elected by shareholders
  • Fiduciary obligation to protect shareholder interests

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Agency Theory

  • Deals with the relationship between
  • Principals – who are owners of the firm (stockholders), and the
  • Agents – who are the people paid by principals to perform a job on their behalf (management)

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Agency Theory: Two Problems

  • Goals of principals and agents may conflict
  • Difficult or expensive for the principal to verify what the agent is actually doing
  • Hard for board of directors to confirm that managers are actually acting in shareholders’ interests
  • Managers may opportunistically pursue their own interests
  • Principal and agent may have different attitudes and preferences toward risk

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Governance Mechanisms: Aligning
the Interests of Owners and Managers

  • Two primary means of monitoring behavior of managers
  • Committed and involved board of directors
  • Active, critical participants in setting strategies
  • Evaluate managers against high performance standards
  • Take control of succession process
  • Director independence
  • Shareholder activism
  • Right to sell stock
  • Right to vote the proxy
  • Right to sue for damages if directors or managers fail to meet their obligations
  • Right to information from the company
  • Residual rights following company’s liquidation

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  • Managerial incentives (contract-based outcomes)
  • Reward and compensation agreements (from TIAA-CREF)
  • Align rewards of all employees (including rank and file as well as executives) to the long-term performance of the corporation
  • Allow creation of executive wealth that is reasonable in view of the creation of shareholder wealth
  • Measurable and predictable outcomes that are directly linked to the company’s performance
  • Market oriented
  • Easy to understand by investors and employees
  • Fully disclosed to investing public and approved by shareholders

Governance Mechanisms: Aligning
the Interests of Owners and Managers

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External Governance
Control Mechanisms

  • Market for corporate control
  • Auditors
  • Banks and analysts
  • Regulatory bodies (Sarbanes-Oxley Act in 2002)
  • Media and public activists

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Major Provisions of Sarbanes-Oxley Act

  • Auditors
  • Barred from certain types of non-audit work
  • Not allowed to destroy records for five years
  • Lead partners auditing a firm should be changed at least every five years
  • CEOs and CFOs
  • Must fully reveal off-balance sheet finances
  • Vouch for the accuracy of information revealed
  • Executives
  • Must promptly reveal the sale of shares in firms they manage
  • Are not allowed to sell shares when other employees cannot

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9

Strategic Control and
Corporate Governance

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