MGMT205 – BUSINESS POLICY AND STRATEGY

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CHAPTER 2 - CORPORATE GOVERNANCE

Objectives:
a.) Describe the role and responsibilities of the board of directors in
corporate governance,
b.) Understand how the composition of a board can affect its
operation,
c.) Describe the impact of the Sarbanes-Oxley Act on corporate
governance in the United States
d.) Discuss trends in corporate governance; and
e.) Explain how executive leadership is an important part of strategic
management.

A. Role of the Board of Directors

- A corporation is a mechanism established to allow different parties to contribute
capital, expertise, and labor for their mutual benefit. The investor/shareholder
participates in the profits of the enterprise without taking responsibility for the
operations. Management runs the company without being responsible for
personally providing the funds. To make this possible, laws have been passed that
give shareholders limited liability and, correspondingly, limited involvement in a
corporation’s activities. That involvement does include, however, the right to elect
directors who have a legal duty to represent the shareholders and protect their
interests. As representatives of the shareholders, directors have both the authority
and the responsibility to establish basic corporate policies and to ensure that they
are followed.
- The board of directors, therefore, has an obligation to approve all decisions that
might affect the long-run performance of the corporation. This means that the
corporation is fundamentally governed by the board of directors overseeing top
management, with the concurrence of the shareholder. The term corporate
governance refers to the relationship among these three groups in determining the
direction and performance of the corporation

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B. Responsibilities of the Board
- Laws and standards defining the responsibilities of boards of directors vary from
country to country.
- The following five board of director responsibilities, listed in order of importance:
1. Setting corporate strategy, overall direction, mission, or vision
2. Hiring and firing the CEO and top management
3. Controlling, monitoring, or supervising top management
4. Reviewing and approving the use of resources
5. Caring for shareholder interests11

C. Members of the Board of Directors

- The boards of most publicly owned corporations are composed of both inside and
outside directors. Inside directors (sometimes called management directors) are
typically officers or executives employed by the corporation. Outside directors
(sometimes called non-management directors) may be executives of other firms but
are not employees of the board’s corporation.
- People who favor a high proportion of outsiders state that outside directors are less
biased and more likely to evaluate management’s performance objectively than are
inside directors.
- Stewardship theory proposes that, because of their long tenure with the
corporation, insiders (senior executives) tend to identify with the corporation and its
success. Rather than use the firm for their own ends, these executives are thus
most interested in guaranteeing the continued life and success of the corporation.
- Those who question the value of having more outside board members point out that
the term outsider is too simplistic because some outsiders are not truly objective
and should be considered more as insiders than as outsiders. For example, there
can be:
o Affiliated directors, who, though not really employed by the corporation,
handle the legal or insurance work for the company or are important
suppliers (thus dependent on the current management for a key part of their
business).

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o Retired executive directors, who used to work for the company, such as
the past CEO who is partly responsible for much of the corporation’s current
strategy and who probably groomed the current CEO as his or her
replacement.
o Family directors, who are descendants of the founder and own significant
blocks of stock (with personal agendas based on a family relationship with
the current CEO).

D. Nomination and Election of Board Members

- Traditionally the CEO of a corporation decided whom to invite to board membership
and merely asked the shareholders for approval in the annual proxy statement. All
nominees were usually elected. There are some dangers, however, in allowing the
CEO free rein in nominating directors. The CEO might select only board members
who, in the CEO’s opinion, will not disturb the company’s policies and functioning.
- Many corporations whose directors serve terms of more than one year divides the
board into classes and staggers elections so that only a portion of the board stands
for election each year. This is called a staggered board.

E. Organization of the Board

- The size of a board in the United States is determined by the corporation’s charter
and its by-laws, in compliance with state laws. Although some states require a
minimum number of board members, most corporations have quite a bit of
discretion in determining board size. The average large, publicly held U.S. firm has
10 directors on its board. The average small, privately held company has four to
five members. The average size of boards elsewhere is Japan, 14; Non-Japan
Asia, 9; Germany, 16; UK, 10; and France, 11.
- Approximately 70% of the top executives of U.S. publicly held corporations hold the
dual designation of Chairman and CEO. (Only 5% of the firms in the UK have a
combined Chair/CEO.)67 The combined Chair/CEO position is being increasingly
criticized because of the potential for conflict of interest. The CEO is supposed to
concentrate on strategy, planning, external relations, and responsibility to the

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board. The Chairman’s responsibility is to ensure that the board and its committees
perform their functions as stated in the board’s charter. Further, the Chairman
schedules board meetings and presides over the annual shareholders’ meeting.
Critics of having one person in the two offices ask how the board can properly
oversee top management if the Chairman is also a part of top management. For
this reason, the Chairman and CEO roles are separated by law in Germany, the
Netherlands, South Africa, and Finland. A similar law has been considered in the
United Kingdom and Australia. Although research is mixed regarding the impact of
the combined Chair/CEO position on overall corporate financial performance, firm
stock price and credit ratings both respond negatively to announcements of CEOs
also assuming the Chairman position.68 Research also shows that corporations
with a combined Chair/CEO have a greater likelihood of fraudulent financial
reporting when CEO stock options are not present.
- Many of those who prefer that the Chairman and CEO positions be combined agree
that the outside directors should elect a lead director. This person is consulted by
the Chair/CEO regarding board affairs and coordinates the annual evaluation of the
CEO.70 The lead director position is very popular in the United Kingdom, where it
originated. Of those U.S. companies combining the Chairman and CEO positions,
96% had a lead director.71 This is one way to give the board more power without
undermining the power of the Chair/CEO. The lead director becomes increasingly
important because 94% of U.S. boards in 2006 (compared to only 41% in 2002)
held regular executive sessions without the CEO being present.72 Nevertheless,
there are many ways in which an unscrupulous Chair/CEO can guarantee a
director’s loyalty. Research indicates that an increase in board independence often
results in higher levels of CEO ingratiation behavior aimed at persuading directors
to support CEO proposals. Long-tenured directors who support the CEO may use
social pressure to persuade a new board member to conform to the group.
Directors are more likely to be recommended for membership on other boards if
they “don’t rock the boat” and engage in low levels of monitoring and control
behavior. Even in those situations when the board has a nominating committee

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composed only of outsiders, the committee often obtains the CEO’s approval for
each new board candidate.

F. Trends in Corporate Governance

- The role of the board of directors in the strategic management of a corporation is
likely to be more active in the future. Although neither the composition of boards nor
the board leadership structure has been consistently linked to firm financial
performance, better governance does lead to higher credit ratings and stock prices.
A McKinsey survey reveals that investors are willing to pay 16% more for a
corporation’s stock if it is known to have good corporate governance. The investors
explained that they would pay more because, in their opinion (1) good governance
leads to better performance over time, (2) good governance reduces the risk of the
company getting into trouble, and (3) governance is a major strategic issue.
- Some of today’s trends in governance (particularly prevalent in the United States
and the United Kingdom) that are likely to continue include the following:
o Boards are getting more involved not only in reviewing and evaluating
company strategy but also in shaping it.
o Institutional investors, such as pension funds, mutual funds, and insurance
companies, are becoming active on boards and are putting increasing
pressure on top management to improve corporate performance. This trend
is supported by a U.S. SEC requirement that a mutual fund must publicly
disclose the proxy votes cast at company board meetings in its portfolio. This
reduces the tendency for mutual funds to rubber-stamp management
proposals.
o Shareholders are demanding that directors and top managers own more
than token amounts of stock in the corporation. Research indicates that
boards with equity ownership use quantifiable, verifiable criteria (instead of
vague, qualitative criteria) to evaluate the CEO. When compensation
committee members are significant shareholders, they tend to offer the CEO

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less salary but with a higher incentive component than do compensation
committee members who own little to no stock.
o Non-affiliated outside (non-management) directors are increasing their
numbers and power in publicly held corporations as CEOs loosen their grip
on boards. Outside members are taking charge of annual CEO evaluations.
o Women and minorities are being increasingly represented on boards.
o Boards are establishing mandatory retirement ages for board members—
typically around age 70.
o Boards are evaluating not only their own overall performance, but also that of
individual directors.
o Boards are getting smaller—partially because of the reduction in the number
of insiders but also because boards desire new directors to have specialized
knowledge and expertise instead of general experience.
o Boards continue to take more control of board functions by either splitting the
combined Chair/CEO into two separate positions or establishing a lead
outside director position.
o Boards are eliminating 1970s anti-takeover defenses that served to entrench
current management. In just one year, for example, 66 boards repealed their
staggered boards and eliminated poison pills.
o As corporations become more global, they are increasingly looking for board
members with international experience.
o Instead of merely being able to vote for or against directors nominated by the
board’s nominating committee, shareholders may eventually be allowed to
nominate board members. This was originally proposed by the U.S.
Securities and Exchange Commission in 2004, but was not implemented.
Supported by the AFL-CIO, a more open nominating process would enable
shareholders to vote out directors who ignore shareholder interests.
o Society, in the form of special interest groups, increasingly expects boards of
directors to balance the economic goal of profitability with the social needs of
society. Issues dealing with workforce diversity and environmental

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sustainability are now reaching the board level. between a CEO and the
board of directors over environmental issues.)

G. The Role of Top Management

- The top management function is usually conducted by the CEO of the corporation
in coordination with the COO (Chief Operating Officer) or president, executive vice
president, and vice presidents of divisions and functional areas.96 Even though
strategic management involves everyone in the organization, the board of directors
holds top management primarily responsible for the strategic management of a firm.

H. Responsibilities of Top Management

- Top management responsibilities, especially those of the CEO, involve getting
things accomplished through and with others in order to meet the corporate
objectives. Top management’s job is thus multidimensional and is oriented toward
the welfare of the total organization. Specific top management tasks vary from firm
to firm and are developed from an analysis of the mission, objectives, strategies,
and key activities of the corporation. Tasks are typically divided among the
members of the top management team. A diversity of skills can thus be very
important. Research indicates that top management teams with a diversity of
functional backgrounds, experiences, and length of time with the company tend to
be significantly related to improvements in corporate market share and profitability.
In addition, highly diverse teams with some international experience tend to
emphasize international growth strategies and strategic innovation, especially in
uncertain environments, to boost financial performance.99 The CEO, with the
support of the rest of the top management team, must successfully handle two
primary responsibilities that are crucial to the effective strategic management of the
corporation: (1) provide executive leadership and a strategic vision and (2) manage
the strategic planning process.

- Executive Leadership and Strategic Vision

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- Executive leadership is the directing of activities toward the accomplishment of
corporate objectives. Executive leadership is important because it sets the tone for
the entire corporation. A strategic vision is a description of what the company is
capable of becoming. It is often communicated in the company’s mission and vision
statements. People in an organization want to have a sense of mission, but only top
management is in the position to specify and communicate this strategic vision to
the general workforce. Top management’s enthusiasm (or lack of it) about the
corporation tends to be contagious. The importance of executive leadership is
illustrated by Steve Reinemund, past-CEO of PepsiCo: “A leader’s job is to define
overall direction and motivate others to get there.”100 Successful CEOs are noted
for having a clear strategic vision, a strong passion for their company, and an ability
to communicate with others. They are often perceived to be dynamic and
charismatic leaders—which is especially important for high firm performance and
investor confidence in uncertain environments. They have many of the
characteristics of transformational leaders—that is, leaders who provide change
and movement in an organization by providing a vision for that change.102 For
instance, the positive attitude characterizing many well-known industrial leaders—
such as Bill Gates at Microsoft, Anita Roddick at the Body Shop, Richard Branson
at Virgin, Steve Jobs at Apple Computer, Phil Knight at Nike, Bob Lutz at General
Motors, and Louis Gerstner at IBM—has energized their respective corporations.
- These transformational leaders have been able to command respect and to
influence strategy formulation and implementation because they tend to have three
key characteristics:
1. The CEO articulates a strategic vision for the corporation: The CEO
envisions the company not as it currently is but as it can become. The new
perspective that the CEO’s vision brings to activities and conflicts gives renewed
meaning to everyone’s work and enables employees to see beyond the details of
their own jobs to the functioning of the total corporation. Louis Gerstner proposed a
new vision for IBM when he proposed that the company change its business model
from computer hardware to services: “If customers were going to look to an
integrator to help them envision, design, and build end to-end solutions, then the

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companies playing that role would exert tremendous influence over the full range of
technology decisions—from architecture and applications to hardware and software
choices.” In a survey of 1,500 senior executives from different countries, when
asked the most important behavioral trait a CEO must have, 98% responded that
the CEO must convey “a strong sense of vision.”
2. The CEO presents a role for others to identify with and to follow: The
leader empathizes with followers and sets an example in terms of behavior, dress,
and actions. The CEO’s attitudes and values concerning the corporation’s purpose
and activities are clear cut and constantly communicated in words and deeds. For
example, when design engineers at General Motors had problems with monitor
resolution using the Windows operating system, Steve Ballmer, CEO of Microsoft,
personally crawled under conference room tables to plug in PC monitors and
diagnose the problem.107 People know what to expect and have trust in their CEO.
Research indicates that businesses in which the general manager has the trust of
the employees have higher sales and profits with lower turnover than do
businesses in which there is a lesser amount of trust.

- The CEO communicates high performance standards and also shows

confidence in the followers’ abilities to meet these standards: The leader
empowers followers by raising their beliefs in their own capabilities. No leader ever
improved performance by setting easily attainable goals that provided no challenge.
Communicating high expectations to others can often lead to high performance.109
The CEO must be willing to follow through by coaching people. As a result,
employees view their work as very important and thus motivating.110 Ivan
Seidenberg, chief executive of Verizon Communications, was closely involved in
deciding Verizon’s strategic direction, and he showed his faith in his people by
letting his key managers handle important projects and represent the company in
public forums. “All of these people could be CEOs in their own right. They are
warriors and they are on a mission,” explained Seidenberg. Grateful for his faith in
them, his managers were fiercely loyal both to him and the company.

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- The negative side of confident executive leaders is that their very confidence may
lead to hubris, in which their confidence blinds them to information that is contrary
to a decided course of action. For example, overconfident CEOs tend to charge
ahead with mergers and acquisitions even though they are aware that most
acquisitions destroy shareholder value. Research by Tate and Malmendier found
that “overconfident CEOs are more likely to conduct mergers than rational CEOs at
any point in time. Overconfident CEOs view their company as undervalued by
outside investors who are less optimistic about the prospects of the firm.”
- Overconfident CEOs were most likely to make acquisitions when they could avoid
selling new stock to finance them, and they were more likely to do deals that
diversified their firm’s lines of businesses.

REFERENCES:

R. Kirkland, “The Real CEO Pay Problem,” Fortune (July 10, 2006), pp.
78–81.

M. Bartiromo, “Bob Nardelli Explains Himself,” Business Week (July 24,

2006), pp. 98–100.

B. Grow, “Renovating Home Depot,” Business Week (March 6, 2006), pp.

50–58.

B. Grow, “Out at Home Depot,” Business Week (January 15, 2007), pp.
56–62.

M. Fetterman, “Boardrooms Open Up to Investors’ Input,” USA

Today (September 7, 2007), pp. 1B–2B.

LINKS

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TOPICS LINKS FOR VIDEO
Role of the Board of Directors https://youtu.be/iMAS4gfsVx0
Responsibilities of the Board https://youtu.be/0UB2Y86N7Vw
Members of the Board of Directors https://youtu.be/4Z34cLREXo0
Nomination and Election of Board https://youtu.be/UId-HTzF4eI
Members
Organization of the Board https://youtu.be/sfmGzsx3pcA
Trends in Corporate Governance https://youtu.be/8-2qFgLBlnI
The Role of Top Management https://youtu.be/nKCDtcMxaR8
Responsibilities of Top Management https://youtu.be/ov_XvKCF71s

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