CH-9-10 Cooperative Strategy – Strategic Management: Concepts and Cases: Competitiveness and Globalization : Chapter Notes

This Document Contains Chapters 9 to 10 Chapter 9 Cooperative Strategy LEARNING OBJECTIVES 1. Define cooperative strategies and explain why firms use them. 2. Define and discuss the three major types of strategic alliances. 3. Name the business-level cooperative strategies and describe their use. 4. Discuss the use of corporate-level cooperative strategies in diversified firms. 5. Understand the importance of cross-border strategic alliances as an international cooperative strategy. 6. Explain cooperative strategies’ risks. 7. Describe two approaches used to manage cooperative strategies. CHAPTER OUTLINE Opening Case Alliance Formation, Both Globally and Locally, in the Global Automotive Industry STRATEGIC ALLIANCES AS A PRIMARY TYPE OF COOPERATIVE STRATEGY Types of Major Strategic Alliances Reasons Firms Develop Strategic Alliances BUSINESS-LEVEL COOPERATIVE STRATEGY Complementary Strategic Alliances Competition Response Strategy Uncertainty-Reducing Strategy Competition-Reducing Strategy Assessing Business-Level Cooperative Strategies CORPORATE-LEVEL COOPERATIVE STRATEGY Diversifying Strategic Alliance Strategic Focus Samsung Electric is Using Diversifying Alliances to Reduce its Dependence on Google’s Android Operating System Synergistic Strategic Alliance Franchising Assessing Corporate-Level Cooperative Strategies INTERNATIONAL COOPERATIVE STRATEGY NETWORK COOPERATIVE STRATEGY Strategic Focus Industrial Clusters: Geographic Centers for Collaborative Partnering Alliance Network Types COMPETITIVE RISKS WITH COOPERATIVE STRATEGIES Managing Cooperative Strategies SUMMARY REVIEW QUESTIONS EXPERIENTIAL EXERCISES VIDEO CASE This Document Contains Chapters 9 to 10 LECTURE NOTES Chapter Introduction: This chapter provides students with a slightly different perspective on strategic management. It represents a shift from achieving strategic competitiveness and above-average returns through competitive strategy to achieving them through cooperative strategies—i.e., competitive advantage gained by cooperating with other firms. OPENING CASE Alliance Formation, Both Globally and Locally, in the Global Automotive Industry A common rationale for alliances is that firms seek out complementary resources from an alliance partner. The Opening Case notes that a new rationale for alliances has emerged in the literature – that firms are often co-located in the same country, and often in the same region of the country, so that it is easier for them to collaborate locally (even though they may compete globally). Examples provided in the Opening Case include the alliances in the auto industry between Peugeot-Citroen and Opel-Vauxhall; Ford and General Motors; Renault and Nissan; and Fiat-Chrysler, Mazda, and Suzuki. As the Opening Case shows, there are a number of rationales for why competitors form alliances and joint ventures in order to meet strategic needs for increased market power, take advantage of complementary assets, and cooperate with close neighbors, often in the same locale. Teaching Note: The Opening Case profiles the cooperative strategies (strategic alliances) that have been established by several automobile manufacturers. Students should realize that cooperative strategies allow firms to combine resources and capabilities that contribute to successful performance. More specifically, these are resources and capabilities that neither partner possesses individually. A good discussion could be initiated by asking students to identify other examples of firms that utilize cooperative strategies and to explain how these cooperative strategies contribute to the success of both partners. 1 Define cooperative strategies and explain why firms use them. A cooperative strategy is a strategy in which firms work together to achieve a shared objective. Cooperative strategy is the third major alternative (internal growth and mergers and acquisitions are the other two) firms use to grow, develop value-creating competitive advantages, and create differences between them and competitors. Thus, cooperating with other firms is another strategy used to create value for a customer that exceeds the cost of creating that value and to create a favorable position in the marketplace relative to the five forces of competition (see Chapters 2 and 4). A collusive strategy is a cooperative strategy through which two or more firms cooperate to raise prices above the fully competitive level. Teaching Note: It should be noted that a more extreme form of collusion exists. Explicit collusion (which is illegal in the United States and most developed economies, except in regulated industries) exists when one firm negotiates a production output and pricing agreement with another firm in an effort to reduce competition. Used more frequently than explicit collusion, tacit collusion is considered later in the chapter in the discussion of business-level cooperative strategies. Teaching Note: It is important to emphasize that strategic alliances can serve a number of purposes, but they are also difficult to manage. • Two-thirds of all alliances have serious problems in their first two years, and as many as 50 percent fail. • A corporate alliance mind-set (one through which both the strengths and risks of a firm’s entire set of alliance relationships are recognized and understood by all involved with alliance formation and use) increases the probability of alliance success. STRATEGIC ALLIANCES AS A PRIMARY TYPE OF COOPERATIVE STRATEGY A strategic alliance is a partnership between firms whereby their resources and capabilities are combined to create a competitive advantage. Many firms, especially large global competitors, establish multiple strategic alliances. As described in the Opening Case, IBM has formed alliances with Sun Microsystems, SAP, Lenovo, and Cisco, among others. The goal with each cooperative relationship is different and very specific. In general, strategic alliance success requires cooperative behavior from all partners. Actively solving problems, being trustworthy, and consistently pursuing ways to combine partners’ resources and capabilities to create value are examples of cooperative behavior known to contribute to alliance success. 2 Define and discuss the three major types of strategic alliances. Three Types of Strategic Alliances Three types of strategic alliances: joint ventures, equity strategic alliances, and nonequity strategic alliances. A joint venture is an alliance where a new, independent firm is formed from two or more partners, with each partner firm contributing some of their resources and capabilities. Joint ventures are effective in establishing long-term relationships and in transferring tacit knowledge. Because it can’t be codified, tacit knowledge is learned through experiences such as those taking place when people from partner firms work together in a joint venture. An equity strategic alliance is an alliance where partner firms own unequal shares of equity in a venture formed by combining some of their resources and capabilities to create a competitive advantage. For example, Citigroup Inc. has formed a strategic alliance with Shanghai Pudong Development Bank Co. through an equity investment totaling 25 percent. This equity strategic alliance served as a launching pad for Citigroup to enter the credit card business in China. A nonequity strategic alliance is an alliance where two or more firms contract to share some of their resources and capabilities to create a competitive advantage. This type of strategic alliance: • Does not establish a separate independent company and therefore firms don’t take equity positions. • Is less formal and demands fewer partner commitments. • Is unsuitable for complex projects requiring effective transfers of tacit knowledge between partners. Typically taking the form of a nonequity strategic alliance, outsourcing is the purchase of a value-creating primary or support activity from another firm. Other types of nonequity strategic alliances include licensing, distribution agreements, supply contracts, and marketing agreements (such as code-sharing agreements among airlines). Reasons Firms Develop Strategic Alliances Technology companies cannot possibly acquire the technology they need fast enough, so partnering becomes essential. Some believe strategic alliances may be the most powerful trend in American business in a century. Among other benefits, strategic alliances allow partners to create value that they couldn’t develop by acting independently and to enter markets more quickly than they could without a partner. In large firms, alliances account for more than 20 percent of revenue and are a prime vehicle for firm growth. In some industries (e.g., airlines), firms compete more alliance against alliance than firm against firm. Firms form strategic alliances to reduce competition, enhance their competitive capabilities, gain access to resources, take advantage of opportunities, and build strategic flexibility. To do so means that they must select the right partners and develop trust. FIGURE 9.1 Reasons for Strategic Alliances by Market Type Figure 9.1 presents reasons for strategic alliances for firms operating in slow-cycle, fast- cycle, and standard-cycle markets. Slow-Cycle: • Gain access to a restricted market • Establish a franchise in a new market • Maintain market stability Fast-Cycle: • Speed up development of new goods or services • Speed up new market entry • Maintain market leadership • Form an industry technology standard • Share risky R&D expenses • Overcome uncertainty Standard-Cycle: • Gain market power • Gain access to complementary resources • Establish better economies of scale • Overcome trade barriers • Meet competitive challenges from other competitors • Pool resources for very large capital projects • Learn new business techniques Slow-Cycle Markets Firms in slow-cycle markets often use strategic alliances to enter restricted markets or to establish franchises in new markets (especially global markets). Slow-cycle markets are becoming rare in the 21st century competitive landscape for several reasons, including the privatization of industries and economies, the rapid expansion of the Internet’s capabilities in terms of the quick dissemination of information, and the speed with which advancing technologies make quickly imitating even complex products possible. Firms competing in slow-cycle markets should recognize the future likelihood that they’ll encounter situations in which their competitive advantages become partially sustainable (in the instance of a standard-cycle market) or unsustainable (in the case of a fast-cycle market). Cooperative strategies can be helpful to firms making the transition from relatively sheltered markets to more competitive ones. Fast-Cycle Markets Fast-cycle markets are entrepreneurial and dynamic, with new products or services imitated rapidly. Cooperative strategies are used to increase the speed of product development or market entry or to improve strategic competitiveness. Standard-Cycle Markets In standard-cycle markets (which are often large and oriented toward economies of scale), alliances are more likely to be between partners with complementary resources and capabilities. Companies also may cooperate in standard-cycle markets to gain market power. 3 Name the business-level cooperative strategies and describe their use. BUSINESS-LEVEL COOPERATIVE STRATEGY A business-level cooperative strategy is used to help the firm improve its performance in individual product markets. There are four business-level cooperative strategies (see Figure 9.2). A firm forms a business-level cooperative strategy when it believes combining its resources and capabilities with one or more partners creates competitive advantages that it can’t create by itself and that will lead to success in a specific product market. Complementary Strategic Alliances Complementary strategic alliances are partnerships that are designed to take advantage of market opportunities by combining partner firms’ resources and capabilities in complementary ways so that new value is created. Vertical Complementary Strategic Alliance A vertical complementary strategic alliance is formed between firms that agree to use their resources and capabilities in different stages of the value chain to create value. Oftentimes, vertical complementary alliances are formed in reaction to environmental changes, thus they serve as a means of adaptation to the environmental changes. A critical issue for firms is how much technological knowledge they should share with their partner. They need the partners to have adequate knowledge to perform the task effectively and to be complementary to their capabilities. Part of this decision depends on the trust and social capital developed between the partners. Figure Note: Figure 9.2 outlines options for business-level cooperative strategies. FIGURE 9.2 Business-Level Cooperative Strategies The four general business level cooperative strategies are: • Complementary strategic alliances (vertical and horizontal) • Competition response strategy • Uncertainty-reducing strategy • Competition-reducing strategy Figure Note: Two types of complementary strategic alliances—vertical and horizontal partnership agreements—are illustrated in Figure 9.2. FIGURE 9.3 Vertical and Horizontal Complementary Strategic Alliances A vertical complementary strategic alliance links suppliers, manufacturers, and/or distributors and represents linkages between different segments of each partner’s value chain. A horizontal complementary strategic alliance is an arrangement that links similar segments of competing firms’ value chains, such as linking R&D or new product development activities. Horizontal Complementary Strategic Alliance Horizontal complementary strategic alliances are partnerships that link similar activities of firms. Horizontal complementary alliances are used to increase each firm’s competitive advantage and often focus on the long-term development of product and service technology. Importantly, horizontal alliances may require equal investments of resources by the partners but they rarely provide equal benefits to the partners. There are several potential reasons for the imbalance in benefits. • Frequently, the partners have different opportunities as a result of the alliance. • Partners may learn at different rates and have different capabilities to leverage the complementary resources provided in the alliance. • Some firms are more effective in managing alliances and in deriving the benefits from them. • The partners may have different reputations in the market thus differentiating the types of actions firms can legitimately take in the marketplace. Competition Response Strategy Cooperative strategic alliances also may be established to enable partner firms to respond to major strategic actions initiated by competitors. Because they can be difficult to reverse and expensive to operate, strategic alliances are primarily formed to respond to strategic rather than tactical actions. Uncertainty-Reducing Strategy Firms also may form strategic alliances to hedge against risk and uncertainty (especially in fast-cycle markets). Alliances are often used where uncertainty exists, such as in entering new product markets or emerging economies. For example, Dutch bank ABN AMRO signed on to a venture called ShoreCap International, which will invest capital in and advise local financial institutions that do small and microbusiness lending in developing countries. Through this cooperative strategy with other financial institutions, ShoreBank (the venture’s leading sponsor) hopes to be able to reduce the risk of providing credit to smaller borrowers in disadvantaged regions. It also hopes to reduce poverty in the regions where it invests. In other cases, firms form alliances to reduce the uncertainty associated with developing new product or technology standards. For example, the alliance between France Telecom and Microsoft is a competition response alliance for France Telecom but it is an uncertainty reducing alliance for Microsoft. Microsoft is using the alliance to learn more about the telecom industry and business. It wants to learn how it can develop software to satisfy needs in this industry. By partnering with a firm in this industry, it is reducing its uncertainty about the market and software needs. And the alliance is clearly designed to develop new products so the alliance reduces the uncertainty for both firms by combining their knowledge and capabilities. Competition-Reducing Strategy Explicit collusion exists when firms get together to negotiate production output and pricing agreements with the goal of reducing competition. Explicit collusion strategies are illegal in the United States and most developed economies (except in regulated industries). Teaching Note: Some firms may adopt explicit alliances to reduce competition that is perceived as potentially destructive or excessive. Examples include the following: • OPEC, which manages the price and output of oil companies in member countries • Manufacturing and distribution cartels in Japan • Industry trade organizations • Government-industry relationships • Direct collusion or price-fixing agreements among participants in an industry or between industry participants and government agencies There are implicit cooperative alliances, such as tacit collusion, which exist when several firms in an industry observe others’ competitive actions and respond to reduce industry output below the potential competitive level to maintain higher-than-competitive prices. Another form of tacit collusion is mutual forbearance, by which firms avoid competitive attacks against rivals they meet in multiple markets. Rivals learn a great deal about each other when engaging in multimarket competition, including how to deter the effects of their rival’s competitive attacks and responses. Given what they know about each other as a competitor, firms choose not to engage in what could be destructive competitions in multiple product markets. Tacit collusion tends to be used as a business-level competition-reducing strategy in highly concentrated industries. At a broad level in free-market economies, governments must determine how rivals can collaborate to increase their competitiveness without violating established regulations. Assessing Business-Level Cooperative Strategies Firms use business-level strategies to develop competitive advantages that can contribute to successful positioning and performance in individual product markets. To develop a competitive advantage using an alliance, the particular set of resources and capabilities that are combined and shared in a particular manner through the alliance must be valuable, rare, imperfectly imitable, and nonsubstitutable. Complementary business-level strategic alliances (especially vertical ones) are the most likely to create sustainable competitive advantage. Horizontal complementary alliances are sometimes difficult to maintain because they are often formed between rival firms. Although strategic alliances designed to respond to competition and to reduce uncertainty can also create competitive advantages, these advantages tend to be more temporary than those developed through complementary (vertical and horizontal) strategic alliances. The primary reason is that complementary alliances have a stronger focus on the creation of value compared to competition-reducing and uncertainty-reducing alliances, which are far more reactive. Of the four business-level cooperative strategies, the competition-reducing strategy has the lowest probability of creating a sustainable competitive advantage. This suggests that companies using such competition-reducing business-level strategic alliances should carefully monitor them as to the degree to which they are facilitating the firm’s efforts to develop and successfully create competitive advantages. 4 Discuss the use of corporate-level cooperative strategi in diversified firms. CORPORATE-LEVEL COOPERATIVE STRATEGY Corporate-level cooperative strategies are designed to facilitate product and market diversification (discussed in Chapter 6) through a means other than a merger or an acquisition. When a firm seeks to diversify into markets in which the host nation’s government prevents mergers and acquisitions, alliances become an especially appropriate option. Corporate-level strategic alliances are also attractive compared to mergers and particularly acquisitions, because they require fewer resource commitments and permit greater flexibility in terms of efforts to diversify partners’ operations. An alliance can be used as a way to determine if the partners might benefit from a future merger or acquisition between them. Figure Note: Figure 9.4 shows the most common corporate-level cooperative strategies. FIGURE 9.4 Corporate-Level Cooperative Strategies The three corporate level strategies are: • Diversifying strategic alliances • Synergistic strategic alliances • Franchising Diversifying Strategic Alliance A diversifying strategic alliance is a corporate-level cooperative strategy in which firms share some of their resources and capabilities to diversify into new product or market areas. Teaching Note: Note that a diversification alliance enables firms that do not want to grow by merger or acquisition to achieve growth by forming strategic alliances. Exiting a strategic alliance is less difficult and less costly compared to divesting an acquisition that did not contribute expected levels of strategic success. In addition, some governments restrict acquisitions (especially horizontal ones) when regulators conclude that horizontal acquisitions foster explicit collusion. Teaching Note: Firms might form a diversifying alliance to determine if a future merger would benefit both parties—e.g., the formation of technology partnerships between GM and Toyota that may lead to broader linkups between the automakers. Highly diverse networks of alliances can lead to poorer performance by partner firms. However, cooperative ventures are also used to reduce diversification in firms that have overdiversified. For example, Fujitsu, realizing that memory chips were becoming a financial burden, dumped its flash-memory business into a joint venture company controlled by Advanced Micro Devices. This alliance helped Fujitsu refocus on its core businesses. STRATEGIC FOCUS Samsung Electric is Using Diversifying Alliances to Reduce Its Dependence on Google’s Android Operating System Samsung has signaled that it will start selling mobile phones featuring a new operating called Tizen, that is backed by Intel and was developed through a partnership with Samsung, Intel, NTT DO CO MO, Inc, and Vodafone Group PLC. This move will reduce Samsung’s reliance on Google’s Android operating system. The intent of the alliance was to support open-source software to ensure that they will not be too dependent upon the Android operating system provided by Google. Samsung and Mozilla have also established an alliance to build a new mobile Web browser. Samsung also uses alliances to develop technologies that it hopes will become industry standards, and thus lead to lower costs. Joint development improves the odds that innovations will be adopted across the industry rather than when it is created by a single company. Another way it uses alliances is to help sell its hardware. Teaching Note: The Strategic Focus gives insight into Samsung’s use of alliances as a form of corporate strategy to reduce its reliance on a single vendor, expand market reach, and develop technology and software that will result in lower costs. Rather than trying to develop everything it needs in-house, Samsung has sought out partners with complementary resources to achieve results. Students should realize that Samsung is a large, successful global company and yet it lacks some of the resources necessary to position itself for future growth. Forming alliances with companies that have the necessary resources should result in benefits for all of the partners. Synergistic Strategic Alliance Synergistic strategic alliances allow firms to combine some of their resources and capabilities to create joint economies of scope between partner firms. These alliances: • Are similar to business-level horizontal complementary strategic alliances at the business level • Create synergy across multiple functions or multiple businesses SBC Communications and EchoStar Communications were synergistically diversified by the arrangement to offer satellite TV billing services through SBC’s system. Thus, a synergistic strategic alliance is different from a complementary business-level alliance in that it diversifies both firms into a new business, but in a synergistic way. Teaching Note: Through technology-oriented synergistic alliances, Toyota is attempting to gain access to technologies that it has had difficulty developing on its own. Avoiding equity alliances, the carmaker elected to link up with GM to develop electric, hybrid, and fuel cell vehicles. The firm has also joined Volkswagen for intelligent transportation systems, recycling, and marketing. In addition, it has a tie-in with Panasonic EV Energy for batteries. Franchising Franchising is a corporate-level cooperative strategy used by a franchisor to describe and control the sharing of its resources and capabilities. In other words, a franchise refers to a contract between two legally independent companies that allows the franchisee to sell the franchisor’s product or do business under its trademarks over a given time and location. Franchising is a popular strategy. In fact, the companies using it account for one-third of annual US retail sales while competing in over 75 industries. Already frequently used in developed nations, franchising is expected to account for significant portions of growth in emerging economies in the 21st century. The most successful franchising strategy is one in which the partners (i.e., franchisor, franchisees) work closely together. The franchisor is to develop programs to transfer knowledge and skills to the franchisees that are needed to successfully compete at the local level, and franchisees should provide feedback to the franchisor regarding how their units could become more effective and efficient. Franchising is a particularly attractive strategy to use in fragmented industries where no firm or small set of firms has a dominant share in the industry, making it possible for a company to gain a large market share by consolidating independent companies through contractual relationships. Assessing Corporate-Level Cooperative Strategies Compared to those at the business-level, corporate-level cooperative strategies are usually broader in scope and more complex, making them relatively more costly. Firms able to develop corporate-level cooperative strategies and manage them in ways that are valuable, rare, imperfectly imitable, and nonsubstitutable (see Chapter 3) develop a competitive advantage that is added to advantages gained through the activities of individual cooperative strategies. Teaching Note: Corporate-level strategic decisions, such as pursuing cooperative strategies and diversification, may be the result of managerial motives instead of the appropriate desire to achieve strategic competitiveness and earn above-average returns for a company. Firms need corporate governance mechanisms to ensure managers do not use alliance strategies inappropriately. For example, without governance, top-level managers can use alliances to: • Increase the size of the business for the purpose of increasing his/her own compensation • Increase his/her worth or value to—or extend his/her tenure with—the firm by being the only top-level manager who understands the intricacies of a network of alliance partners Note: Managers may use the intricacy of alliance networks to enrich their own position in the firm since alliances can be built on an upper-level manager’s personal contacts, which may be lost if that person leaves the company, thus making dismissal difficult. 5 Understand the importance of cross-border strategic alliances as an international cooperative strategy. INTERNATIONAL COOPERATIVE STRATEGY A cross-border strategic alliance is an international cooperative strategy in which firms with headquarters in different nations combine some of their resources and capabilities to create a competitive advantage. There are several reasons for the increasing use of cross-border strategic alliances: • Multinational corporations outperform firms operating on only a domestic basis. • A firm can form cross-border strategic alliances to leverage core competencies that are the foundation of its domestic success to expand into international markets. • Limited domestic growth opportunities also cause firms to use cross-border alliances. • Government economic policies can influence firms to form cross-border alliances. • Strategic alliances with local partners can help firms overcome certain liabilities of moving into a foreign country, such as lack of knowledge of the local culture or institutional norms. • Firms also use cross-border alliances to help transform themselves to better use their competitive advantages to exploit opportunities surfacing in the rapidly changing global economy. In general, cross-border alliances are more complex and risky than domestic strategic alliances. NETWORK COOPERATIVE STRATEGY Rather than cooperative alliances between two or very few firms, alliances can also be expanded to include a larger number (or network) of partners as a complement to other forms of cooperative strategy. This is a network cooperative strategy. A network cooperative strategy is particularly effective when it is formed by geographically clustered firms, as in California’s Silicon Valley and Singapore’s Silicon Island. Effective social relationships and interactions among partners while sharing their resources and capabilities make it more likely that a network cooperative strategy will be successful, as does having a productive strategic center firm. Firms involved in networks of alliances tend to be more innovative than firms that are not involved in these networks. However, disadvantages to participating in networks include: • becoming locked into partnerships that preclude the development of alliances with others; • firms in a network are expected to help other network firms whenever support is required. Teaching Note: The strategic approach of networks is discussed in this chapter whereas the structural characteristics of network organizations is covered in Chapter 11. STRATEGIC FOCUS Industrial Clusters: Geographic Centers for Collaborative Partnering Industrial clusters typically are formed to improve productivity, lower costs, and facilitate innovation. Governments generally support (and incentivize) the development of clusters because they spur economic development. They are commonly located close to universities to tap into research expertise and take advantage of the graduate labor pool that they produce. Research shows that industrial clusters are associated with higher employment and wage growth, growth in the number of new establishments, and an increase in innovation and patenting (with firms in centralized positions having more and better innovation). Strong clusters tend to support the development of related clusters in the region and/or adjoin region. In addition, there is a demonstrated positive individual effect on human capital development in clusters. Globally experience with clusters has produced varying results. For example, research shows that specializing in one area of R&D without added diversification leads to eventual failure. Overall, the history of industrial clusters is positive and they are being developed on a continual basis. Teaching Note: The Strategic Focus discusses an important organizational arrangement called industrial clusters. Ask students to identify some industrial clusters of which they are aware. Most will be familiar with Silicon Valley. Ask students to do a little research on Silicon Valley and the businesses and institutions that are located in this area. They should come to realize that there is a synergistic effect among the many interrelated organizations that compose this important cluster. Once they are aware of organizations that comprise the cluster they should be able to identify some of the innovations that have been produced through alliances among them. Alliance Network Types An important advantage of a network cooperative strategy is that firms gain access to the partners of their partners. The set of partnerships, such as strategic alliances, that result from the use of a network cooperative strategy is commonly called an alliance network. Stable alliance networks often appear in mature industries with predictable market cycles and demand. Through a stable alliance network, firms try to extend their competitive advantages to other settings while continuing to profit from operations in their core, relatively mature industry. Teaching Note: An example of a US firm’s stable network is Nike’s long- established relationships between the firm and its global network of suppliers and distributors. Dynamic alliance networks often are used in industries with frequent technological innovation and short product life cycles. Thus, dynamic alliance networks are primarily used to stimulate rapid, value-creating product innovations and subsequent successful market entries. 6 Explain cooperative strategies’ risks. COMPETITIVE RISKS WITH COOPERATIVE STRATEGIES Many cooperative strategies fail. Evidence suggests that two-thirds of cooperative strategies have serious problems in their first two years and that as many as 70 percent of them eventually fail. This failure rate suggests that even when the partnership has potential synergies, alliance success can be elusive. The risks associated with cooperative strategies are significant because the firms that are cooperating may also be competing with each other. These risks include: • Poor contract development that may result in one (or more) of the partners acting opportunistically and taking advantage of other venture partners • Misrepresentation of partner firms’ competencies by misstating or exaggerating an intangible resource such as knowledge of local market conditions • Failure of partner firms to make complementary resources available to the venture as agreed • The possibility that a firm may make investments that are specific to that alliance while its partner does not Figure Note: Competitive risks of cooperative strategies, as well as risk management approaches, are summarized in Figure 9.5. FIGURE 9.5 Managing Competitive Risks in Cooperative Strategies As Figure 9.5 indicates, The competitive risks of cooperative strategies are • Inadequate contracts • Misrepresentation of competencies • Partners failing to use complementary resources • Holding alliance partners’ specific investments hostage And can be managed by • Detailed contracts and monitoring • Developing trusting relationships to ensure that the strategy creates value. 7 Describe two approaches used to manage cooperative strategies. MANAGING COOPERATIVE STRATEGIES Cooperative strategies are an important option for firms competing in the global economy; however, they are complex and challenging to manage. The two basic approaches to managing cooperative strategies are: • Cost minimization • Opportunity maximization In the cost-minimization approach, the firm develops formal contracts with its partners. These contracts specify how the cooperative strategy is to be monitored and how partner behavior is controlled. The goal of this approach is to minimize the cooperative strategy’s cost and to prevent opportunistic behavior by partners. The opportunity-maximization approach focuses on a partnership’s value-creation opportunities. In this case, partners are prepared to take advantage of unexpected opportunities to learn from each other and to explore additional marketplace possibilities. Less formal contracts, with fewer constraints on partners’ behaviors, make it possible for partners to explore how their resources and capabilities can be shared in multiple value- creating ways. Firms can successfully use both approaches to manage cooperative strategies. However, the costs to monitor the cooperative strategy are greater with cost minimization, in that writing detailed contracts and using extensive monitoring mechanisms is expensive, even though the approach is intended to reduce alliance costs. As a strategic asset, trust can enable partner firms to reduce the cost of contracting and monitoring because the probability of opportunistic behavior is reduced if partners are able to trust each other. Trust also may enable the venture to take advantage of unforeseen opportunities. Because trust enables partner firms to reduce venture-related contracting and monitoring costs and increase venture flexibility, a venture between trusted partners is more likely both to reduce costs and add/create value. Chapter 10 Corporate Governance LEARNING OBJECTIVES 1. Define corporate governance and explain why it is used to monitor and control top-level managers’ decisions. 2. Explain why ownership is largely separated from managerial control in organizations. 3. Define an agency relationship and managerial opportunism and describe their strategic implications. 4. Explain the use of three internal governance mechanisms to monitor and control managers’ decisions. 5. Discuss the types of compensation executives receive and their effects on managerial decisions. 6. Describe how the external corporate governance mechanism—the market for corporate control—restrains top-level managers’decisions. 7. Discuss the nature and use of corporate governance in international settings, especially in Germany, Japan, and China. 8. Describe how corporate governance fosters ethical decisions by a firm’s top-level managers. CHAPTER OUTLINE Opening Case The Imperial CEO, J.P. Morgan Chase’s Jamie Dimon: Is It the End of Corporate Governance? SEPARATION OF OWNERSHIP AND MANAGERIAL CONTROL Agency Relationships Product Diversification as an Example of an Agency Problem Agency Costs and Governance Mechanisms OWNERSHIP CONCENTRATION The Increasing Influence of Institutional Owners BOARD OF DIRECTORS Enhancing the Effectiveness of the Board of Directors Executive Compensation The Effectiveness of Executive Compensation Strategic Focus CEO Pay and Performance: Board Revolution at Citigroup MARKET FOR CORPORATE CONTROL Managerial Defense Tactics Strategic Focus Rewarding Top Executives of One of the Worst-Performing Food Companies in the World: The Chinese Takeover of Smithfield Foods INTERNATIONAL CORPORATE GOVERNANCE Corporate Governance in Germany and Japan Corporate Governance in China GOVERNANCE MECHANISMS AND ETHICAL BEHAVIOR SUMMARY REVIEW QUESTIONS EXPERIENTIAL EXERCISES VIDEO CASE LECTURE NOTES Chapter Introduction: The purpose of this chapter is to present and discuss how shareholders (owners) can ensure that managers develop and implement strategic decisions in the best interests of the shareholders (owners) and not be primarily self-serving (working for the best interests of managers only, to the detriment of shareholders). In the absence of effective internal governance mechanisms, the market for corporate control—an external governance mechanism—may be activated. Though it is a subject most frequently associated with firms in the US and the U.K., the effectiveness of governance is gaining attention throughout the world. The chapter begins by describing the relationship that provides the foundation on which the modern corporation is built—i.e., the relationship between owners and managers. However, the majority of this chapter is devoted to an explanation of various mechanisms owners use to govern managers and ensure maximization of shareholder value. OPENING CASE The Imperial CEO, J.P. Morgan Chase’s Jamie Dimon: Is It the End of Corporate Governance? Jamie Dimon, CEO of J.P. Morgan Chase survived the Great Recession quite well. However, in 2012 it suffered losses of more than $6 billion due to excessive risk taking by traders in its London operations. Some of the loss was attributed to poor oversight at the top. Shareholder activists sought, unsuccessfully, to split the positions of CEO and Chair of the Board. Executives and board members at J.P. Morgan Chase worked to keep the positions together. This is a statement on governing (in)effectiveness at the firm. The Opening Case speculates that because the same ownership structure exists at seven of the firm’s ten largest institutional investors’ firms, and that because these investors want banks to engage in high risk activities (because the downside risk of loss to them is low) these investors prefer the status quo governance arrangement. Whatever the reasons, this case does demonstrate how weak shareholder rights are in the U.S. and that boards seldom act in ways that are counter to effective oversight and control. The focus of the Opening Case provides an overview of some of the important issues related to corporate governance. At its core, corporate governance deals with the actions of top-level managers and the responsibilities of the board of directors to ensure managers are acting in appropriate ways. Thus, corporate governance is concerned with issues such as organization effectiveness, transparency, accountability, incentivizing actions, and creating value (for stakeholders and shareholders). Corporate governance is important to individual companies because effective governance should result in superior performance. It is also an important concern to nations because in the global economy, capital flows toward opportunity. Effective governance is part of the equation for ensuring competitiveness and, subsequently, acceptable returns. Teaching Note: Effective corporate governance has been a critical issue for the past several decades. Unfortunately, minimal real progress has been made in this area. For all the grand gestures and corporate/governmental assurances, effectiveness, transparency, accountability, use of incentives, and value creation all have a lot of room for improvement. Ask students to identify contemporary governance issues/governance breakdowns and to speculate about why the issue/breakdown exists. Ask them to identify the weak points in the system. Though students are probably unfamiliar with governance systems in other countries, they should realize that effective governance is a global concern, not just a national one. 1 Define corporate governance and explain why it is used to monitor and control top-level managers’ decisions. Corporate governance is the set of mechanisms used to manage the relationship among stakeholders and to determine and control the strategic direction and performance of organizations. At its core, corporate governance is concerned with identifying ways to ensure that strategic decisions are made effectively. Corporate governance has been emphasized in recent years because, as the opening case illustrates, corporate governance mechanisms increasingly affect all stakeholders and the firm's future. Effective corporate governance is also of interest to nations. Governments want firms operating within their countries to grow and provide employment, wealth, and satisfaction. This raises standards of living and enhances social cohesion. Three internal governance mechanisms examined here are (1) ownership concentration, as represented by types of shareholders and their different incentives to monitor managers, (2) the board of directors, and (3) executive compensation. The external governance mechanism is the market for corporate control. Teaching Note: In the chapter, corporate governance is discussed from two perspectives: • The primary purpose of governance mechanisms is to prevent severe problems that may occur because of the separation of ownership and control in large firms by positively influencing managerial behavior. • The ability of governance mechanisms to direct top mangers’ actions toward shareholder objectives is dependent on the correct combination of mechanisms being used. 2 Explain why ownership is largely separated from managerial control in organizations. SEPARATION OF OWNERSHIP AND MANAGERIAL CONTROL The growth of the large, modern public corporation is based primarily on the efficient separation of ownership and managerial control. Shareholders make investments by purchasing stock (representing ownership), which entitles them to a share of the firm’s residual income (or profits) that remain after all expenses have been paid. • The right to share in residual income also means that shareholders also must accept the risk that no residual profits will remain if the firm’s expenses exceed its income. • Shareholders can manage investment risk by investing in a diversified portfolio of firms. • In small firms, managers and owners are often one in the same—less separation of ownership and control. • As family-controlled firms grow, the owners generally do not have sufficient capital or managerial skills to grow the business and seek other sources of capital and skills to support this expansion. Teaching Note: It is helpful to provide a story that would illustrate what the separation of ownership and managerial control is all about, and how it came to be. For example, it is easy for students to see that Henry Ford was involved in both the ownership and the operation of Ford Motor Company in the early days. They can see in their minds the old footage of Model T’s coming off a very crude assembly line, by today’s standards, and understand how much simpler operations were at the time. That has all changed with the advent of the modern, complex corporation. Today there is almost no way to bring ownership and managerial control back together again in a workable model. 3 Define an agency relationship and managerial opportunism and describe their strategic implications. Agency Relationships Although the efficient separation of ownership and control enables specialization both by owners and managers, it also results in some potential costs (and risks) for owners by creating an agency relationship. An agency relationship exists when one party (the principal[s]) delegates decision making to another party (the agent[s]) in return for compensation as a decision-making specialist who performs a service. This relationship can be broader than just owners and managers—e.g., consultants and clients or insured and insurer. Figure Note: Figure 10.1 illustrates how separation of ownership from control results in an agency relationship and is very helpful in getting students to understand the issues involved. FIGURE 10.1 An Agency Relationship Note the following in the figure (Figure 10.1): • Shareholders (principals) hire managers (agents) as decision makers. • The hiring act creates an agency relationship wherein a risk-bearing specialist (principal) compensates a managerial decision-making specialist (agent). The potential for conflicts of interests between owners and managers is created by the delegation of the responsibilities of decision making to managers. Therefore, managers may take actions that are not in the best interests of owners by selecting strategic alternatives that serve managerial interests rather than shareholder or owner interests. An agency relationship enables the possibility of managerial opportunism, the seeking of self-interest with guile (i.e., with cunning or deceit), where opportunism is represented by an attitude or inclination and a set of behaviors. Before observing the results of decisions, it is impossible to know which agents will behave opportunistically and which ones will not because a manager’s reputation is an imperfect guide to future behavior. As a result, principals establish governance and control mechanisms because the opportunity for opportunistic behavior and conflicts of interest exists. Product Diversification as an Example of an Agency Problem Product diversification—discussed in Chapter 6—can be beneficial to both shareholders and managers, but it also is a potential source of agency problems. Managers may pursue higher levels of product diversification than are desired by shareholders to capture the value of opportunities that are available to managers, but not to owners. • Increased diversification generally drives the growth of the firm and firm growth is positively related to managerial compensation. Thus, by diversifying to a greater extent than may be desired by shareholders, managers may enjoy the higher levels of compensation that accompany managing larger firms. • Increased diversification also can reduce managerial employment risk (the risk of job loss, loss of compensation, or loss of managerial reputation). Increased diversification reduces managerial employment risk because the firm (and the manager) is less affected by a reduction in demand for (or failure of) a single product line when the firm produces and sells multiple products. • Increased diversification also may provide managers with access to increased levels of slack resources or free cash flows, resources that are generated after investment in all internal projects that have positive net present values within the firm’s current product lines. Managers may choose to invest excess funds in products or activities that are not related to the firm’s existing core businesses and products if they perceive attractive (positive net present value) investment opportunities. Figure Note: Figure 10.2 illustrates the variance between the risk profiles of shareholders and managers based on the level or type of firm diversification. It shows that owners may benefit from managers’ decisions to diversify the firm’s products, but only to the point where investment returns at the margin are no longer positive. That is, diversification is valuable to (and preferred by) owners as long as it has a positive effect on firm value. However, some firms may be overdiversified, despite the lack of profitability in their dominant business. Owners also may prefer that excess funds be returned to them in the form of dividends so they can control reinvestment decisions. FIGURE 10.2 Manager and Shareholder Risk and Diversification Curve S represents the business or investment risk profile for shareholders (owners). It spans a diversification scope from dominant business (which would be to the left of related- constrained) to a point between related-constrained and related-linked diversification. The optimum risk level is at point A, between dominant business and related-constrained diversification. Curve M represents the managerial employment risk profile. It spans a diversification profile from related-constrained to unrelated diversification. The optimum diversification level for managers is point B, between related-linked and unrelated businesses. As illustrated by the S-curve (owner business risk preference) and M-curve (managerial employment risk preference), there is a conflict between owners and managers regarding the desired levels of firm diversification and risk. • Owners prefer that the scope be greater than a dominant business but less than related- linked diversification. • Owners’ optimum level of diversification is where the S curve turns up, a point between dominant business and related-constrained diversification. • Managers prefer a greater scope of diversification than owners. As can be seen from the M curve in Figure 10.2, managers prefer that the firm’s diversification be between related- linked and unrelated diversification. • However, as the curve indicates, there is a point at which managerial employment risk increases as the firm overdiversifies (as discussed in Chapter 6). • The optimum level of firm diversification from a managerial risk perspective is at point B on the M curve, somewhere between related-linked and unrelated businesses. Agency Costs and Governance Mechanisms The potential conflict illustrated by Figure 10.2, coupled with the fact that principals do not know which managers might act opportunistically, demonstrates why principals establish governance mechanisms. For firm diversification to approach the shareholder optimum (point A on curve S in Figure 10.2), managerial autonomy must be controlled by the firm’s board of directors or by other governance mechanisms that encourage managers to make strategic decisions that are in the best interests of shareholders. Agency costs are the sum of incentive, monitoring, and enforcement costs as well as any residual losses incurred by principals because it is not possible for principals to guarantee 100 percent compliance through monitoring arrangements. Research suggests that more intensive application of governance mechanisms may produce significant changes in strategies. Corporate America needs more intense governance in order for continued investment in the stock market to facilitate growth. However, others argue that the indirect costs are even more telling in regard to the impact on strategy formulation and implementation. Partly in response to governance breakdowns in the U.S., Congress enacted the Sarbanes- Oxley (SOX) Act in 2002 and passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in 2010. Most believe that SOX has led to generally positive outcomes in terms of protecting shareholders. Section 404 of SOX, for example, improves transparency and internal controls and this, subsequently, increases shareholder value. However, this resulted in increased costs to firms and a decrease in foreign firms listingon U.S. stock exchanges. Dodd-Frank is the most sweeping set of financial regulatory reforms in the U.S. in almost a century. Dodd-Frank: • Created a Financial Stability Oversight Council headed by the Treasury Secretary • Established a new system for liquidation of certain financial companies • Provided for a new framework to regulate derivatives • Established new corporate governance requirements • Regulated credit rating agencies and securitizations • Established a new consumer protection bureau and provided for extensive consumer protection in financial services 4 Explain the use of three internal governance mechanisms to monitor and control managers’ decisions.e of three internal governance mechanisms to monitor and control managers’ decision OWNERSHIP CONCENTRATION Ownership concentration is defined both by the number of large-block owners and by the total percentage of the firm’s shares that they own. Large-block shareholders are investors who typically own at least five percent of the firm’s shares. Diffuse ownership (a large number of shareholders with small holdings and few/no large- block shareholders) • Produces weak monitoring of managerial decisions • Makes it difficult for owners to coordinate their actions effectively • May result in levels of diversification that are beyond the optimum level desired by shareholders (especially when this condition is combined with weak monitoring) The Increasing Influence of Institutional Owners In recent years, large-block ownership by individuals has declined, but they have been replaced by significant positions held by institutional owners. Institutional owners are large-block shareholder positions controlled by financial institutions, such as stock mutual funds and pension funds. The importance of institutional owners is indicated by the fact that these shareholders now control over 50 percent of the stock in large US corporations and approximately 56 percent of the stock of the 1,000 largest US corporations. These ownership percentages suggest that as investors, institutional owners have both the size and the incentive to discipline ineffective top-level managers and can significantly influence a firm’s choice of strategies and overall strategic decisions. Initially, these shareholder activists and institutional investors concentrated on the performance and accountability of CEOs and contributed to the ouster of a number of them. They are now targeting what they believe are ineffective boards of directors. The rising tide of shareholder pressure also is evidenced by actions taken by CalPERS. • CalPERS provides retirement and health coverage to over 1.3 million current and retired public employees. • CalPERS is generally thought to act aggressively to promote decisions and actions that it believes will enhance shareholder value in companies in which it invests. • Institutions’ activism may not have a direct effect on firm performance, but its influence may be indirect through its effects on important strategic decisions. Teaching Note: Students should know about a few of the more common anti- takeover provisions. For example, a golden parachute is a type of managerial protection that pays a guaranteed salary for a specified period of time in the event of a takeover and the loss of one’s job. A golden goodbye provides automatic payments to top executives if their contracts are not renewed, regardless of the reason for nonrenewal. In the case of acquisitions, managers may receive this compensation even if they voluntarily decide to quit. Other defense strategies are described in greater detail in Table 10.2. BOARD OF DIRECTORS Even though institutional ownership has increased, the majority of firms still “enjoy” the benefits or advantages of diffuse ownership (i.e., limited monitoring of managers by individual shareholders). Furthermore, large financial institution shareholders—such as banks—are effectively prevented from having direct ownership of firms and are prohibited from placing a representative on the boards of directors. These conditions highlight the importance of boards of directors to corporate governance. Teaching Note: Legally, the board of directors has broad powers, including: • Directing the affairs of the organization • Punishing (disciplining) and rewarding (compensating) managers • Protecting the rights and interests of shareholders (owners) Boards are experiencing increasing pressure from shareholders, lawmakers, and regulators to become more forceful in their oversight role and thereby forestall inappropriate actions by top executives. The board of directors is a group of elected individuals whose primary responsibility is to act in the owners’ interests by formally monitoring and controlling the corporation’s top-level executives. If the board of directors is appropriately structured and operates effectively, it can protect owners from managerial opportunism. Table Note: Table 10.1 provides characteristics of three classifications of members of the board of directors: insiders, related outsiders, and outsiders. These will be useful for students as you discuss board effectiveness. TABLE 10.1 Classifications of Board of Director Members Insiders are represented by the firm’s CEO and other top-level managers. Related outsiders are individuals who are not involved in the firm’s day-to-day operations, but may have a relationship with the company. Examples might include the firm’s legal counsel, a large customer or supplier, or a close relative of one of the firm’s top-level managers. Outsiders are individuals who are independent of the firm. They are neither involved in the firm’s day-to-day operations, nor do they have other relationships with the firm. An example of an outsider might be the president of a university or a community volunteer. Because the primary role of the board of directors is to monitor and ratify major managerial actions to protect the interests of owners, there is a call by advocates of board reform that outsiders should represent a significant majority of a board’s membership. Teaching Note: Outside directors (and boards) are perceived as ineffective because: • Insiders dominate the board by limiting the flow of information to outside directors. • Outside directors are nominated for board membership by insiders (primarily by the CEO) and thus are indebted to insiders. The drawbacks of outside boards: • Because outside directors do not have day-to-day contact with the ongoing operations of the firm, they must obtain detailed, in-depth information about the quality of management decisions. Generally this information is obtained through frequent interactions, often developed over time, with inside directors (generally, at board meetings). • In the absence of rich information, boards may be forced to emphasize financial rather than strategic controls. Potentially, this means that outsider-dominated boards—because they lack sufficient information—will evaluate managers not on the basis of the appropriateness of their actions (which the board ratified) but based on the financial outcomes of those actions. Enhancing the Effectiveness of the Board of Directors Because of the board’s importance, the performance of individual board members as well as that of entire boards is being evaluated more formally and intensely. Many boards have voluntarily initiated changes, including: • Increasing the diversity of board members’ backgrounds • Strengthening internal management and accounting control systems • Establishing and consistently using formal processes to evaluate the board’s performance • Creating a “lead director” role that has strong powers with regard to the board agenda and oversight of nonmanagement board member activities • Changing the director compensation, especially reducing or eliminating stock options as part of the package Teaching Note: The following comments can be used to expand the class discussion of whether a more active board is a more effective board. The findings from research regarding the effectiveness of board involvement in the strategic decision-making process are mixed, indicating the following: • Board involvement in the strategic decision-making process may improve firm performance because it provides the firm’s managers with access to outside opinions, and outside directors should be more objective and interested in protecting owner interests. • Boards are more likely to be involved in strategic decisions when the firm is smaller and less diversified, since information regarding strategic actions is more readily available and both the scope and size of the firm are manageable. • Boards are less active in large, diversified firms. • The board’s access to sufficiently rich information on appropriateness of strategic actions in large diversified firms is limited. • Board may be limited to evaluating financial outcomes (instead of action appropriateness). Teaching Note: McKinsey & Co. research found that institutional shareholders were willing to pay an 11 percent premium for the shares of companies when outsiders constitute a majority of the board, own significant amounts of stock, are not personally tied to top management, and when management is subjected to formal evaluation. Research shows that boards working collaboratively with management: • Make higher quality strategic decisions • Make decisions faster • Become more involved in the strategic decision-making process Because of the increased pressure from owners and the potential conflict among board members, procedures are necessary to help boards function effectively in facilitating the strategic decision-making process. Increasingly, outside directors are being required to own significant equity stakes as a prerequisite to holding a board seat. In fact, some research suggests that firms perform better if outside directors have such a stake. One activist concludes that boards need three foundational characteristics to be effective: director stock ownership, executive meetings to discuss important strategic issues, and a serious nominating committee that truly controls the nomination process to strongly influence the selection of new members. 5 Discuss the types of compensation executives receive and their effects on managerial decisions. Executive Compensation As illustrated in the opening case and Strategic Focus, the compensation of top-level managers generates great interest and strongly held opinions. One reason for this widespread interest can be traced to a natural curiosity about extremes and excesses. But furthermore, CEO pay is an indirect but tangible way to assess governance processes in large corporations. Executive compensation is a governance mechanism that seeks to align managers’ and owners’ interests through salary, bonus, and long-term incentive compensation such as stock options. Sometimes the use of a long-term incentive plan prevents major stockholders (e.g., institutional investors) from pressing for changes in the composition of the board of directors, because they assume that long-term incentives ensure that top executives will act in shareholders’ best interests. Alternatively, stockholders largely assume that top-executive pay and the performance of a firm are more closely aligned when firms have boards that are dominated by outside members. Using executive compensation as a governance mechanism is more challenging in international firms. Evidence suggests that the interests of owners of multinational corporations may be served best when the firm’s foreign subsidiary compensation plans are customized to local conditions. Though unique compensation plans require additional monitoring and increase the firm’s agency costs, it is important to adjust pay levels to match those of the region of the world (e.g., higher in the US and lower in Asia). Teaching Note: When DaimlerBenz acquired Chrysler, it highlighted the fact that top executives at Chrysler made much more than the executives at DaimlerBenz—but higher-paid Chrysler executives report to lower-paid Daimler bosses. This example is one that students seem to be able to grasp. Developing and implementing an effective incentive compensation program is quite challenging because: • Strategic decisions made by top managers are complex and non-routine. Due to difficulties in judging decision quality, compensation is often linked to more measurable outcomes such as financial performance. • Decisions made by top-level managers are likely to affect firm performance over an extended period of time. As a result, it is difficult to assess the effect of current decisions using current period performance. • Many variables (or outside factors) intervene between management behavior and firm performance (e.g., uncontrollable shifts in the environment). Although incentive compensation plans may increase the value of a firm in line with shareholder expectations, such plans are subject to managerial manipulation. Although long-term performance-based incentives may reduce temptations to under-invest in the short run, they increase executive exposure to risks associated with uncontrollable events—e.g., market shifts, industry decline. The Effectiveness of Executive Compensation The compensation received by top-level managers, especially by CEOs, is often a subject of controversy. Large CEO compensation packages result mostly from the inclusion of stock options and stock in the total pay packages. This is intended to entice executives to keep the stock price high, thus aligning manager and owner interests. Research has shown that managers owning more than one percent of the firm’s stock are less likely to be forced out of their jobs, even when the firm is performing poorly. Furthermore, a review of the research suggests that over time, firm size has accounted for more than 50 percent of the variance in total CEO pay, whereas firm performance has accounted for less than 5 percent of the variance. Teaching Note: One way that boards have found to compensate executives is through giving them loans with favorable, or no, interest for the purpose of buying company stock. If done correctly, this can be a governance tool, since it aligns executives’ priorities with those of the shareholders because the executives hold stock, not just options on the stock. They gain or lose money along with the shareholders. It is important to consider that annual bonuses may provide incentives to pursue short-run objectives at the expense of the firm’s long-term interests. Although some stock-option-based compensation plans are well designed with option strike prices substantially higher than current stock prices, too many have been designed simply to give executives more wealth that will not immediately show up on the balance sheet. Research of stock option repricing where the strike price value of the option has been lowered from its original position suggests that action is taken more frequently in high-risk situations. However, it also happens when firm performance was poor to restore the incentive effect for the option. Often, organizational politics play a role in this. Repricing stock options does not appear to be a function of management entrenchment or ineffective governance. These firms often have had sudden and negative changes to their growth and profitability. They also frequently lose their top managers. Interestingly, institutional investors prefer compensation schemes that link pay with performance, including the use of stock options. Again, this evidence shows that no internal governance mechanism is perfect. Option awards became a means of providing large compensation packages, and the options awarded did not relate to the firm’s performance, particularly when boards showed a propensity to reprice options at a lower strike price when stock prices fell precipitously. Option awards are becoming increasingly controversial. Teaching Note: Board directors also receive compensation. Some recent figures follow: • Median base compensation for directors in telecommunications was almost $90,000. • Directors at Microsystem Inc. received average compensation of about $410,000 a year, whereas directors at Compaq earned over $360,000 and directors at Pfizer received almost $260,000. • On average, directors at the largest 200 firms received about $134,000. • Similar to executives in the firm, there is a move by large institutional investors such as CalPERS to pay directors at least partially in stock (some estimating that some 50 percent of director pay will be in company stock). STRATEGIC FOCUS CEO Pay and Performance: Board Revolution at Citigroup Vikram Pundit was appointed as CEO of Citigroup in 2007 to address problems that arose from the financial meltdown in the U.S. that began in that year. He brought in a new management team, eliminated about 11,000 jobs, and sold off some business units. While Citi produced a small profit in 2010 and $11 billion in 2011, shareholder value decreased by 89 percent during his tenure. A new board chair, Michael O’Neill, was appointed in 2012. In 2012 shareholders were given a vote on Pandit’s proposed compensation package of $14.9 million and 55 percent voted against it. Pandit clashed with O’Neill on executive team pay and for his failure to secure backing from the Fed to return capital to shareholders. Pandit was forced to resign in October 2012 and the company instituted changes in the way top executives would be paid. Instead of deferred cash compensation, performance pay became based on stock grants tied to the bank’s shareholder value relative to peer banks, and return on assets, that vested three years in the future. Teaching Note: The Strategic Focus makes clear how controversial executive pay (especially in the US) can be. Most students will have an opinion about executive pay. Ask if students believe top corporate executives are paid too much, too little, or are fairly compensated for what they do. Ask proponents of each side to provide some justification for their positions. Point out that numerous examples exist in which executives received handsome pay increases even though their companies lost value (hurting shareholders) and earnings were down. Ask students how they think executive pay should be structured so that executives are fairly paid for the work they do and how their pay should relate to shareholder value. Ask students how effective they think of the board of directors and executive compensation are as governance mechanisms. 6 Describe how the external corporate governance mechanism— the market for corporate control—restrains top-level managers’decisions. MARKET FOR CORPORATE CONTROL The market for corporate control generally comes into use as an external governance mechanism only after internal governance mechanisms have failed. A Brief History of the Market for Corporate Control The market for corporate control has been active for some time. The 1980s were known as a time of merger mania, with around 55,000 acquisitions valued at approximately $1.3 trillion. However, there were many more acquisitions in the 1990s, and the value of mergers and acquisitions in that decade was more than $10 trillion. The major reduction in the stock market resulted in a significant drop in acquisition activity in the first part of the 21st century. However, the number of mergers and acquisitions began to increase in 2003, and the market for corporate control has become increasingly international with over 40 percent of the merger and acquisition activity involving two firms from different countries. Though some acquisition attempts are intended to obtain resources important to the acquiring firm, most of the hostile takeover attempts are due to the target firm’s poor performance. Therefore, target firm managers and members of the boards of directors are highly sensitive about hostile takeover bids. It often means that they have not done an effective job managing the company because of the performance level inviting the bid. If they accept the offer, they are likely to lose their jobs; the acquiring firm will insert its own management. If they reject the offer and fend off the takeover attempt, they must improve the performance of the firm or risk losing their jobs as well. The market for corporate control is an external governance mechanism that becomes active when a firm’s internal controls fail. It is composed of individuals and firms who buy ownership positions in (or take over) potentially undervalued firms. They do this in order to form a new division in an established diversified firm, merge two previously separate firms, and usually replace the target firm’s management team to revamp the strategy that caused low firm performance. The market for corporate control governance mechanism should be triggered by a firm’s poor performance relative to industry competitors. A firm’s poor performance, often demonstrated by the firm’s earning below-average returns, is an indicator that internal governance mechanisms have failed; that is, their use did not result in managerial decisions that maximized shareholder value. Managerial Defense Tactics Because of the threat of dismissal, managers have devised a number of defensive tactics designed to both ward off takeovers and buffer or protect managers from external governance mechanisms. These tactics include: • Managerial pay interventions, such as golden parachutes • Asset restructuring, such as divesting a business unit or division • Financial restructuring—e.g., stock repurchases, paying out a firm’s free cash flows as a dividend • Changing the state of incorporation • Making targeted shareholder repurchases (known as greenmail) TABLE 10.2 Hostile Takeover Defense Strategies This table presents a number of defense strategies and identifies them according to category (preventive, reactive), popularity (high, medium, low, very low), effectiveness (high, medium, low, very low), and stockholder wealth effects (positive, negative, inconclusive). The defense strategies mentioned are poison pill, corporate charter amendment, golden parachute, litigation, greenmail, standstill agreement, and capital structure change. Most institutional investors oppose the use of defense tactics. For example, TIAA-CREF and CalPERS have taken actions to have several firms’ poison pills eliminated. The market for corporate control also can be plagued by inefficiency. In the 1980s, roughly 50 percent of all takeovers targeted firms that were high performers. As a result, • Acquisition prices were excessive • Expensive defensive strategies were often implemented to protect the firm Despite its inefficiency, the threat of acquisition by corporate raiders can serve as an effective constraint on the managerial growth motive and result in strategies that are in the best interests of the firm’s owners. Teaching Note: As mentioned throughout the chapter, internal and external governance mechanisms, though they may restrain managerial actions, are imperfect means of controlling managerial opportunism. This means that some combination of both internal and external mechanisms is necessary. STRATEGIC FOCUS Rewarding Top Executives of One of the Worst-Performing Food Companies in the World: The Chinese Takeover of Smithfield Foods Smithfield Foods is the largest pork producer in the U.S with about 11 percent of sales coming from foreign markets. However, Smithfield has delivered a return of negative 18 percent over the five year period ending in March 2013 (with no dividend distribution). Smithfield was the second worst U.S. food producer with sales over $10 billion. During this time competitors Tyson and Hormel paid dividends of $429 million and $728 million, respectively. Chinese firm Shuanghui International has made an offer to purchase Smithfield at a 31 premium to market price. Because of “change of control” provisions, if the deal is completed Smithfield executives would receive $85.4 million and all be retained in their positions. If their employment is terminated before two years they will receive a minimum $126.4 million. Teaching Note: The Strategic Focus further illustrates how controversial executive pay (especially in the US) can be and how ineffective corporate governance is in some corporations. While it is clear that shareholder interests have been given a low priority by Smithfield management, it is also painfully obvious that shareholders have been let down by the Smithfield board of directors. Ask students to explore the ethical dimensions of executive compensation that are evident in the Strategic Focus. 7 Discuss the nature and use of corporate governance in international settings, especially in Germany, Japan, and China. INTERNATIONAL CORPORATE GOVERNANCE Our discussion of internal and external governance mechanisms—and their effectiveness in controlling managerial behavior—has been centered on the US and the U.K. But this does not necessarily apply to the systems of corporate governance used elsewhere in the world, e.g., German and Japanese firms. Although the stability that has been associated with the German and Japanese systems has been perceived as a strength, it is possible, given the dynamic and uncertain nature of the new competitive landscape, that stability may be a potential source of weakness. Corporate Governance in Germany and Japan The owner-manager relationship in Germany differs from that described for the US. For example: • In many private German firms, the owner and manager are the same person. • In publicly traded firms there often is a dominant shareholder. Banks historically have occupied a central position in German governance structure. • Banks became major shareholders when companies they financed either sought new capital in the stock market or defaulted on loans. • Banks generally hold less than 10 percent of a firm’s stock. • Bank ownership of a single firm’s stock is limited to 15 percent of the bank’s capital. • Three large banks—Deutsche, Dresdner, and Commerzbank—hold majority positions in large German firms through their own holdings and proxy votes for shareholders who retain shares with the banks. • German firms with more than 2,000 employees must have a two-tiered board structure, with supervision of management being separated from other board duties and all of the functions of direction and management being placed in the hands of the Vorstand or management board. • Appointment to the management board is the responsibility of the Aufsichtsrat or supervisory board. Despite the ability of major owners and banks to monitor and control the managers of large German firms, maximizing shareholder value has not been a historical focus. However, this is changing. Teaching Note: A shift is taking place in German firms’ historic lack of focus on maximizing shareholder value. For example, SGL Carbon AG lost more than $71 million in the early 1990s and was later restructured to turn the corporation around. In particular the firm’s governance structure was changed, transparent accounting practices were adopted, and the firm set a goal of enhancing shareholder value. The firm’s performance has since improved, and many attribute this to the new governance structure. Corporate governance in Japan is affected by the concepts of obligation, family, and consensus. In Japan, obligation goes beyond principles but is more a product of specific causes, events, and relationships. It can mean returning a service for one that has been rendered. The concept of family goes beyond the American concept to include the firm—individuals see themselves as members of a company family. And the family concept is extended to include members of the firm’s keiretsu, a group of firms that are tied together by cross- shareholdings, interrelationships, and interdependencies. Consensus represents one of the most important influences on governance structure in Japan. This requires that managers—among others—expend significant amounts of energy to win the hearts and minds of people rather than proceed by the edicts of top-level managers. As in Germany, banks also play an important role in financing and monitoring large public firms in Japan. • The bank owning the largest share of stocks and the largest amount of debt—the main bank—has the closest relationship with the company’s top executives. • Banks occupy an important position in the governance system, both financing and monitoring firms. • The main bank—the bank holding the largest share of a firm’s debt—provides financial advice and assumes primary responsibility for monitoring the firm’s management. • Japanese banks can hold up to five percent of a firm’s stock. • Groups of banks can hold up to 40 percent of a firm’s stock. • In many cases, bank relations are an integral part of the Japanese firm’s keiretsu (an industrial group of firms that interact with the same bank). Teaching Note: Keiretsus are both diversified and vertically integrated to the extent that they generally include one or more firms in almost all important industrial sectors. As in Germany, Japan’s corporate governance structure is changing. For example, the role of banks in the monitoring and control of managerial behavior and firm outcomes has become less significant. Corporate Governance in China Corporate governance in China has undergone major changes over the past decade, along with the privatization of business and the development and integrity of the equity market. Though these changes are significant, the state still dominates the strategies that most firms employ. Research indicates that firms with higher state ownership have lower market value and more volatility than those with less. This is due to the fact because the state imposes social goals on these firms and executives are not trying to maximize shareholder wealth. Overall, the Chinese system of corporate governance has been moving toward a Western- style model. Chinese executives are also being compensated based on the firm’s financial performance. Teaching Note: Examples of differences and changes in international governance follow: • In France, anger has been growing over the lack of information on top executive compensation. A recent report recommended that the positions of CEO and chairman of the board be held by two different individuals. It also recommended reducing the tenure of board members and disclosing their pay. • In South Korea, principles of corporate governance are being adopted to provide proper board and management incentives to pursue the interests of both the company and the shareholders and to facilitate effective monitoring. • Changes in corporate governance are occurring even in transitional economies, such as China and Russia, though implemented more gradually. The use of stock-based compensation plans has influenced foreign companies to invest (particularly in China). 8 Describe how corporate governance fosters ethical decisions by a firm’s top-level managers. GOVERNANCE MECHANISMS AND ETHICAL BEHAVIOR Governance mechanisms discussed in this chapter focus on ensuring that managers work effectively toward meeting their obligation to maximize shareholder wealth. However, shareholders are only one group of the firm’s stakeholders (as discussed in Chapter 1). Over the long term, the demands of other key stakeholders—such as employees, customers, suppliers, and the community—also must be satisfied in order to maximize shareholder wealth. For that reason and others, governance mechanisms must be carefully designed and implemented so that managers’ attention is not focused on maximizing short-term returns and to ensure that they consider the interests of all stakeholders. Teaching Note: John Smales (outside director of the board at GM) has commented that the most fundamental obligation of management is to perpetuate the organization, taking priority even over stockholder interests. His comments may provide a good opportunity to engage students in a discussion about the purpose of the firm and its obligations to all stakeholders. Instructor Manual for Strategic Management: Concepts and Cases: Competitiveness and Globalization Michael A. Hitt, R. Duane Ireland, Robert E. Hoskisson 9781285425184, 9781285425177, 9780538753098, 9781133495239, 9780357033838, 9781305502208, 9781305502147