Chapter 11: Corporate Performance, Governance, and Business Ethics

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CHAPTER 11

Corporate Performance, Governance, and

Business Ethics
SYNOPSIS OF CHAPTER
Chapter 11 introduces concepts related to strategy implementation. The first section addresses the causes of poor
performance, which occurs in some firms in every industry. Causes of poor performance include poor
management, high costs, inadequate differentiation, overexpansion, shifts in demand, and organizational inertia.
The chapter then suggests ways that firms can improve poor performance, such as changing leadership, changing
strategy, or changing the organization.
The chapter then describes the ways in which various stakeholder groups make contributions to, and receive
benefits from, the organization, and how stakeholder support leads to high organizational performance. Managers
dont always act in the best interests of stakeholders, and this chapter uses agency theory to explain this difficulty
and to suggest ways to overcome it.
Next, corporate governance is presented, including boards of directors, compensation for principals,
independently audited financial statements, the threat of corporate takeover, strategic control systems, and
incentive systems. Each of these governance mechanisms is described in detail, and the costs and benefits of each
are provided.
The final topic of the chapter is ethics. Business ethics are defined and described. Then, suggestions are given to
help improve an organizations ethical performance.

TEACHING OBJECTIVES
1.

Introduce concepts about strategy implementation.

2.

Describe reasons for poor performance and suggest ways to improve poor performance.

3.

Identify important stakeholder groups, show how they contribute to and benefit from the firm, and describe
how stakeholders affect corporate profitability.

4.

Familiarize students with agency theory, and use it to explain why a misalignment of interests exists at
every level of the organization.

5.

Present information about various corporate governance mechanisms.

6.

Define and describe business ethics, and show how managers can improve a firms ethical performance.

OPENING CASE: THE FALL OF ENRON

Enron was one of the worlds largest energy traders in 2000; by 2001, it was bankrupt. Enron fell so rapidly
because it held $27 billion in hidden debt, with most investors and regulators completely unaware of the firms
true financial position. The partnerships were set up in compliance with regulations, but they were a way of
boosting Enrons apparent profitability for the enrichment of a few corrupt executives. These top managers reaped
millions from the sale of their Enron stock, then abruptly left the firm. It seems clear that a few managers were
deliberately misleading investors. And the companys independent auditor, Arthur Andersen came under suspicion
for its role in the debacle and has also declared bankruptcy. More than one employee attempted to blow the
whistle on the suspect transactions, but Enron management took no action. The outcome? Thousands of lost jobs,
billions of dollars in lost shareholder wealth.

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Chapter 11: Corporate Performance, Governance, and Business Ethics

Teaching Note: The Enron case highlights the importance of good strategic control and other corporate
governance mechanisms. Enrons board, its auditors, and its bankers have all been held partially responsible for
the mess. However, poor ethics seems to be at the heart of it all. Management was apparently committing
deliberate fraud, although a legal outcome for the case may be years away. This is a tale of governance and ethics
gone horribly wrong and provides a sobering note for students as they approach the topics in this chapter.

LECTURE OUTLINE
I.

II.

Overview
A. This chapter examines the issues and factors that can prevent a companys strategies from being
implemented in a way that will lead to superior profitability, along with strategies for raising
performance.
B.
Corporate governance and business ethics are two tools that can be used to ensure that managers act
in the best interests of stakeholders.
The Causes of Poor Performance
A. Virtually every industry contains some firms, and in some industries, many firms, that are not
profitablethat is, whose returns do not exceed their cost of capital.
B.
There are six causes of persistent poor performance that are found in many organizations. When
organizations are declining, typically they are experiencing several of these factors simultaneously.
1.
Poor management is a cause of persistent poor performance, and it covers a variety of
problems, from neglect to outright incompetence.
a.
Poor managers are too dominant, autocratic, or overly-ambitious.
b.
Another characteristic of poor managers is trying to do too much by themselves, rather
than delegating appropriately.
c.
Other characteristics include the lack of a succession plan, failure by the board of
directors, or a lack of strong middle managers.
d.
Poor managers sometimes execute strategies that are designed to enrich themselves,
rather than the firms shareholders.
2.
Another hallmark of poorly-performing organizations is a high cost structure, which is often
due to low labor or capital productivity.
a.
Low labor productivity stems from union work restrictions, lack of investments in laborsaving technology, or lack of employee incentives.
b.
Low capital productivity is caused by failure to fully use the companys fixed assets, such
as occurs when a firm has low economies of scale or holds too much inventory.
c.
Low productivity is usually tied to deeper problems, such as lack of accountability for
financial returns.
3.
Companies whose products lack adequate differentiation will suffer from low performance.
a.
Poor product quality or lack of attractive product attributes contributes to lack of
differentiation.
b.
Lack of differentiation can usually be traced to deeper problems, such as a failure to
implement cross-functional product development teams or failure to implement quality
improvement processes.
4.
Another contributor to poor performance is overexpansion, which occurs when a company tries
to move into too many diversified industries too quickly.
a.
Overexpansion often results when an autocratic CEO tries an empire-building strategy,
with poorly conceived diversification leading to disappointing results.
b.
Overexpansion also tends to raise a companys debt burden rapidly, and that may be
untenable, particularly if economic conditions decline.
5.
Poor performance arises when industries experience a structural shift, that is, a shift in
demand that is permanent, often brought on by technological, economic, or social changes.
a.
These shifts revolutionize industry dynamics and threaten existing firms (although they
also create opportunities for new entrants).
b.
Structural shifts are difficult to predict and the entrance of new competitors creates
significant upheaval for existing firms.
6.
Organizational inertia also plays a role in poor performance, because it slows the firms
response to changes and problems.

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Chapter 11: Corporate Performance, Governance, and Business Ethics

a.

III.

IV.

133

The existing distribution of power within a firm causes individual managers to resist
change, leading to organizational inertia.
b.
Deeply-held values and norms can provide benefits to the firm, but they can also be very
hard to change, contributing to inertia.
c.
Managers preconceptions about their firms business model may go unchallenged,
creating an inability to see the need for change, and thus leading to inertia.
Strategic Change: Improving Performance
A. Most companies that are attempting to improve performance change leadership.
1.
The old leaders are seen as contributing to the problems, whereas new leaders from outside the
company will bring in fresh perspectives and ideas, overcoming preconceptions.
2.
The new leaders must be able to make difficult decisions, motivate and listen to others, and
delegate when appropriate.
B.
Changing strategy is another common tactic to improve performance.
1.
Strategy must first be evaluated and redefined, if necessary. For a single-business firm,
redefining the strategy means changes in the generic business-level strategy. For diversified
firms, it means re-evaluating and balancing the firms portfolio of businesses.
2.
Next, a firm must divest or liquidate any assets that do not contribute to the new strategy. The
resulting cash can be used to improve the remaining operations.
3.
Then a firm should focus attention on improving efficiency, quality, innovation, and
responsiveness to customers. (This was described in detail in Chapter 4.) This will involve
activities such as laying off excess employees, reengineering processes, and introducing total
quality management programs.
4.
Acquisitions can also be used to improve performance, if the acquired company strengthens the
firms competitive position in its core operations.
C.
Firms can also improve performance through a change in the organization.
1.
The first step in organizational change is to unfreeze the company, that is, to shock the
employees in such a way that they understand and agree with the necessity for change.
a.
Reorganizations or plant closings are often used as a way to signal the need for change to
employees.
b.
The commitment of senior managersas evidenced by both their words and their actions
facilitates lower-level employees making the change.
2.
After the organization is shocked into unfreezing, it can be moved into its desired state.
a.
Moving the organization requires actions, such as redesigning processes, reorganizing the
structure, reassigning responsibilities, new control and reward systems, firing people who
refuse to change, and so on.
b.
The changes must be substantial, in order to have an important impact on performance,
and they must be rapid, to ensure success.
3.
Refreezing, or making the new way of doing business the firms established practice, follows
movement.
a.
Management education programs, hiring individuals whose values support the new state
of the organization, and implementing consistent control and reward systems are all part
of refreezing.
b.
Senior leaders must be consistent in their words and actions throughout the entire change
and refreezing period. Also, they must be patient because changing an organizations
values and culture takes time.
Stakeholders and Corporate Performance
A. Stakeholders are individuals or groups with an interest, or stake, in a firm. Internal stakeholders
include stockholders and employees at all levels. External stakeholders are all other groups, and
typically include customers, suppliers, creditors, governments at all levels, unions, local communities,
and the general public.
Show Transparency 67
Figure 11.1: Stakeholders and the Enterprise

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Chapter 11: Corporate Performance, Governance, and Business Ethics

B.

Stakeholders are in a reciprocal relationship with the firm, providing the organization with resources
and expecting some benefit in return.
1.
Each stakeholder group has a unique relationship with the firm.
a.
Stockholders provide funds and expect returns.
b.
Creditors provide funds and expect repayment and interest.
c.
Employees provide labor, skills, and ideas, and expect income, job satisfaction and
security, and good working conditions.
d.
Customers provide sales revenues and expect products that provide value for money.
e.
Suppliers provide inputs and expect revenues and dependable buyers.
f.
Governments provide regulation and expect companies to adhere to the rules.
g.
Unions provide productive employees and expect income and other benefits for their
members.
h.
Local communities provide local infrastructure and expect companies to behave as
responsible citizens.
i.
The general public provides national infrastructure and expects the company to improve
their quality of life.
2.
Companies that neglect to satisfy the needs of one or more important stakeholder groups will
find that the stakeholders withdraw their support, damaging the firm.

STRATEGY IN ACTION 11.1: BILL AGEE AT MORRISON KNUDSEN

Bill Agee was a manager with a troubled historyaccounting overstatements made while he was chief financial
officer at papermaker Boise Cascade, promoting a female colleague with whom he was having an affair while
CEO of defense contractor Bendix. Agee became CEO of construction contractor Morrison Knudson (MK) in
1988, with a plan to update the firms assets and to pursue new contracts aggressively. The plan seemed to be
working, but trouble signs soon appeared. Aggressive bidding led to low profits on large construction jobs, and
most of the firms earnings came from risky securities trading. Employees became disgruntled over Agees selfpromoting style, firing of long-time top managers, and high compensation and perquisites. Finally, an anonymous
letter to MKs board of directors led to a full investigation. When financial mismanagement was revealed, Agee
was ousted. Shareholder lawsuits caused MK to make a $63 million settlement, and Agee was required to return
some of his severance pay and pension benefits.
Teaching Note: Agees tenure at MK was a study in how to offend stakeholders. He was unable to effectively lead
employees, and stockholders were displeased with MKs poor performance, blaming him.
C.

D.

A company cannot fully satisfy all of its stakeholders at the same time. To understand stakeholder
needs and to develop effective strategies for satisfying those needs, companies use stakeholder impact
analysis.
1.
To begin a stakeholder impact analysis, a company must first identify stakeholder groups, along
with their interests and concerns.
2.
Next, a company must identify the claims that each stakeholder group is likely to make on the
organization.
3.
Then, a company must decide the relative importance of each stakeholder group, from the
companys perspective.
4.
This process will result in an identification of some critical strategic challenges.
5.
Based on this process, most firms identify the three most important stakeholder groups as
customers, employees, and stockholders.
Among stakeholders, stockholders position is unique because the stockholders are the legal owners
of the firm as well as the providers of funds. Their unique position leads to an emphasis on satisfying
the needs of this key stakeholder group.
1.
The money provided by stockholders is called risk capital, because the stockholders are
making a risky investment in the firm with no guarantee of returns or even the preservation of
their original investment.
2.
Because of their willingness to assume risk, managers are obliged to reward stockholders by
pursuing strategies that maximize returns to them.
3.
When employees become stockholders too, for example through employee stock ownership
plans (ESOPs), the importance of maximizing stockholder return grows.

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Chapter 11: Corporate Performance, Governance, and Business Ethics

E.

135

Companies can satisfy stakeholder claims by increasing profitability.

1.
Managers can best serve the interests of stockholders (the most important group of
stakeholders) by increasing profitability.
a.
Stockholders receive returns as dividends and as appreciation in share value.
b.
Increasing profitability (that can be measured by ROIC) tends to both increase the funds
available for dividends and to drive up the value of the stock.
2.
Profitability satisfies the claims of several other stakeholder groups, in addition to stockholders.
a.
Higher profits generate more funds for paying high salaries and offering more benefits to
employees.
b.
Higher profits generate more funds for satisfying debt obligations to creditors.
c.
Higher profits generate more funds for philanthropic activities, which benefit local
communities and the general public.
3.
The cause-and-effect relationship between profitability and satisfying stakeholder claims shows
that profitability must be the cause, leading to the ability to satisfy.
a.
If the relationship works in the opposite direction, where stakeholders must first be
satisfied before the firm can be profitable, the results are overly high costs and no
guarantee that the firm can bear those costs.
b.
Once a company is profitable, then it can satisfy stakeholders. In return, satisfied
stakeholders provide more generously for the firm, which leads to further increases in
profitability. Thus the process is a self-reinforcing cycle. See Figure 11.2 for a graphic
depiction of the process.
Show Transparency 68
Figure 11.2: Relationship Between ROIC, Stakeholder Satisfaction, and Stakeholder Support
4.

Not all stakeholder groups are satisfied by high profitability.

a.
Suppliers want to sell to a profitable company, because it will pay for what it receives.
Customers want to buy from a profitable company that will exist long enough to provide
customer service and additional sales. However, neither group wants the firm to profit at
their expense.
b.
Governments expect every company to make profits only within the limits set by law. The
general public expects companies to profit in a manner consistent with societal
expectations.
c.
Every stakeholder group disapproves of the unfettered pursuit of profit, if it leads to
unethical or illegal behavior.

STRATEGY IN ACTION 11.2: PRICE FIXING AT SOTHEBYS AND CHRISTIES

Sothebys and Christies, the two largest fine art auction houses in the world, were earning low commissions in
the 1990s, as sellers negotiated simultaneously with both firms for the best rates. Sothebys CEO, Dede Brooks,
secretly met with CEO Christopher Davidge of Christies, to establish together a fixed, nonnegotiable rate
structure. This had the effect of illegally fixing prices and reducing competition. The deal was exposed, and the
auction houses paid settlements to sellers that totaled $512 million, in addition to federal fines. The conspirators,
and the chairmen that were their superiors, lost their jobs and received jail time or probation from federal courts.
Teaching Note: In this case, illegal price fixing led to higher commissions paid by sellers. It also might have
contributed to buyers paying higher prices, as sellers tried to recover some of their additional expenses. Finally, it
was not in the best interests of shareholders, because the lawsuits and fines led to lower profitability. Use this case
to spark classroom discussion by asking students to examine other times when corporations acted to either protect
stakeholder interests or hurt their interests by acting unethically or illegally. Examples could include Exxons
cover-up of the Valdez oil spill, Union Carbides Bhopal disaster, or Johnson & Johnsons exemplary response to
Tylenol tampering. After describing the facts of the situation, ask students to indicate how the corporations
actions either helped or hurt stakeholders.

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V.

Chapter 11: Corporate Performance, Governance, and Business Ethics

Agency Theory
A. Agency theory looks at the problems that can arise in a business relationship when one person
delegates decision making authority to another. It offers a way to understand why managers do not
always act in the best interests of stakeholders.
B.
An agency relationship occurs whenever one person delegates decision-making authority to another.
The principal is the person delegating authority, and the agent is the person to whom the authority is
delegated.
C.
The agency problem is that principals and agents may have different goals, and therefore, that agents
may act in ways that are not in the best interests of their principals.
1.
Agents may do this because of information asymmetry, that is, because the agent almost
always has more information about the resources they are managing than does the principal.
2.
Thus, it is difficult for the principals to measure the agents performance or to hold them
accountable for their performance.
3.
To some extent, its impossible for a principal to know for sure whether the agent is acting in
the principals best interests, and so the principal must trust the agent.
4.
The principals also make efforts to monitor agents, evaluate their performance, and if necessary,
take corrective actions.
D. The agency problem exists in corporations, as stockholders (the principals) are the companys owners,
but they delegate decision-making power to the companys managers (the agents).
1.
Managers, like other people, desire status, power, job security, and income. They can use their
decision-making authority and control over corporate funds to satisfy those desires at the
expense of stockholders. This is called on-the-job consumption.
2.
Boards of directors typically make executive pay decisions, in order to control expenses.
However, CEOs can use their influence with the board to get pay increases. The historically
high level of CEO pay in the U.S. can be attributed to this cause.
a.
CEO pay is rapidly increasing and is at the highest level it has ever been.
b.
CEO pay is rising more rapidly than workers pay. In 1980, the average CEO earned 42
times what the average worker did; by 1990, CEO pay was 400 times greater.
c.
CEO compensation is increasing, including stock options or other forms of indirect
payment. For most CEOs, stock options are a far bigger part of their total compensation
than is their base salary.
d.
CEO compensation doesnt seem to be linked to corporate profitability; many CEOs of
companies that posted an overall financial loss received large increases in pay for that
same period.
3.
To increase power, status, and income, a CEO might engage in empire building, that is, buying
many new businesses to increase the size of the firm through diversification.
a.
Empire building, which is diversifying without an appropriate reason for doing so,
reduces profitability, because funds are now used to pay the debt incurred to finance
growth.
Show Transparency 69
Figure 11.3: The Tradeoff Between Profitability and Revenue Growth Rates
b.

E.

Too much growth too quickly also leads organizations to pay too much for acquisition
targets, further depressing profits.
The agency problem also exists in the relationship between higher-level managers and their lowerlevel subordinates. For example, a subordinate may withhold information to increase his pay or job
security or get more than his units fair share of organizational resources.

STRATEGY IN ACTION 11.3: THE AGENCY PROBLEM AND THE COLLAPSE OF

BARINGS BANK
Barings Bank of England, a 233-year-old institution with a venerable history, was made bankrupt in 1995 by the
actions of just one employee, 27-year-old Nick Leeson, of the firms Singapore office. Although young, Leeson
was a trusted securities trader. However, his compensation and position within the firm were both based upon the
profitability of his trades, encouraging him to take very high risks in exchange for potentially high returns (or

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Chapter 11: Corporate Performance, Governance, and Business Ethics

137

potentially high losses). At first his moves were profitable, but when the Nikkei stock exchange became more
volatile, the losses began to mount. Leeson reaction was to bet bigger. His colleagues believed Leeson was using
funds from a client, but in fact, he had used Barings own money to set up a trading account. Lack of controls and
monitoring allowed the charade to continue until Barings had no money left. Leeson ultimately served jail time,
and several other Barings executives lost their position, but the penniless firm was sold to ING, a Dutch bank, for
$1.
Teaching Note: Leeson exploited the information asymmetry that existed between himself and senior managers to
pursue his own interests. Ask students to describe other situations that they are aware of, either from business or
their own experiences, in which the agency problem was present. Ask them to answer these questions: What led
to the problem?, What was the outcome?, and How could the situation have been handled differently so as to
reduce or eliminate the problem?
VI.

Governance Mechanisms
A. Governance mechanisms are put in place by principals to align agents incentives with their own,
and to monitor and control agents.
B.
There are four main types of governance mechanisms.
1.
U.S. and U.K. firms tend to rely heavily upon corporate boards of directors, elected by
stockholders, to represent the interests of the stockholders.
a.
Boards of directors are charged with several responsibilities.
(1) Boards of directors are legally responsible for the firms actions and act to oversee
the actions of the firms CEO and top managers.
(2) The board makes decisions about hiring, firing and compensating top corporate
executives.
(3) The board ensures that the audited financial statement, which is the primary
reporting tool from managers to stockholders, presents a true picture of the
organizations health.
b.
Boards of directors are typically composed of a mix of corporate insiders and outsiders.
(1) Inside directors are senior employees of the firm and are charged with bringing
information about the company to the board. However, they are employees and
their interests tend to be aligned with management.
(2) Outside directors are not full-time corporate employees, and they are charged with
bringing objectivity to the board. Full-time professional directors hold positions on
several boards and do a good job, because their professional reputations are at
stake.
c.
Many boards perform admirably, but some, such as that of Enron, do not.
(1) One criticism of boards of directors is that insiders often dominate and therefore
can manipulate perceptions.
(2) Another criticism of boards is that many are dominated by the CEO, particularly
when the CEO is also chairman of the board. When this occurs, the CEO may
choose both the inside and the outside directors, who may feel loyalty to the CEO
or allow the CEO to control the agenda.
d.
In recent years, boards of directors have been playing a more active role in corporate
governance.
(1) One reason for the enhanced oversight is the lawsuits that stockholders have filed
against board members. In some cases, board members must pay damages out of
their own pocket.
(2) Another rationale for active boards of directors is the increasing number of
institutional investors, such as the managers of large pension funds, that are putting
their own employees on the boards of firms whose stock they own.
(3) Other trends in increased vigilance include boards calling for CEO removal and an
increase in outsiders serving as chairmen.
2.
Another governance is stock-based compensation for principals. If agents are working under a
pay-for-performance system, then it will be in their best interests to increase profitability.
a.
The most common pay-for-performance grants stock options to managers, which give
them the right to buy shares at a predetermined price (called the strike price) at some

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Chapter 11: Corporate Performance, Governance, and Business Ethics

3.

point in the future. Typically, the strike price is the trading price at the time the option
was granted.
b.
However, when CEOs exercise their options several years later, their compensation
increases dramatically. Some claim that stock options are too generous, especially when
the strike price is set deliberately low.
c.
Another criticism of stock options is that issuing more shares of stock dilutes the equity
of the existing stockholders. Some critics would like options to be shown on financial
statements as an expense, but at this time, companies are not required to do so, although
some do so voluntarily. Table 11.1 shows the significant impact that this change in
accounting policy would have on several firms stated earnings.
A third governance mechanism is the use of independently audited financial statements.
a.
Publicly traded companies are required to file with the Securities and Exchange
Commission periodic statements that comply with Generally Accepted Accounting
Principles (GAAP).
b.
To ensure that the statements are consistent, detailed, and accurate, companies must
employ independent auditors to evaluate each statement.
c.
However, although most companies file accurate statements and most auditors do a
careful job reviewing that information, a minority of companies have abused the system,
in some cases aided by their auditors.

STRATEGY IN ACTION 11.4: DID COMPUTER ASSOCIATES INFLATE REVENUES

TO ENRICH MANAGERS?
The share price of Computer Associates stock rose during the 1990s, as revenues increased. Three of the
companys top executives were looking forward to bonus compensation of over $1 billion total, if the stock price
remained high over 60 days. COO Sanjay Kumar announced high earnings, the stock rose above the trigger price
and remained there, and they received their bonuses. Less than one month after the bonus was awarded, Kumar
announced that earnings would fall substantially. CEO Charles Wang resigned, and Kumar took on the position,
but federal regulators investigated the firm. They found evidence to support their contention that the firms
executives deliberately overstated earnings in order to achieve the bonus, and that they did so with the help of
their auditors, KPMG and Ernst & Young. Stockholders claim that the value of their shares was reduced; the case
is ongoing.
Teaching Note: This case illustrates the hazards of inadequate or inappropriate controls, both in pay-forperformance and in reliance upon auditors oversight. As in the Strategy in Action 11.3 about Barings Bank,
managers were encouraged by the structure of their compensation to commit acts that increased their pay, rather
than acts that would further the firms long-term interests. Also, independent auditors failed to discover or report,
or perhaps even conspired in, unethical financial reporting. For classroom discussion purposes, ask students to
comment on the following statement: A white-collar crime, such as banking fraud or cooking the books, isnt a
serious crime because it doesnt really hurt anyone.
(1)

4.

One problem is that GAAP guidelines are loose enough that they can be
manipulated by unethical managers.
(2) It also appears that sometimes auditors face a conflict of interest in auditing the
books of companies that also have lucrative consulting contracts. Thus, the
accountants may be reluctant to blow the whistle and risk losing a client.
(3) Boards of directors are supposed to be the ultimate overseers of financial
statements, and apparently they are not always careful enough. Too many inside
directors adds to this concern.
(4) In 2002, new legislation was passed, in response to Enron and other accountingdriven debacles. The law solved some problems but not all. In addition the true
problem may not be too few laws, but too little enforcement of existing laws.
Yet another corporate governance mechanism is the threat of a hostile takeover. This could
happen if many stockholders decide to sell the stock, causing the value of the shares to decline
below the book value of its assets. An acquirer could then purchase the firm, sell the assets, and
profit. This threat is called the takeover constraint.

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Chapter 11: Corporate Performance, Governance, and Business Ethics

139

a.

5.

In the 1980s and early 1990s, hostile takeovers were executed by corporate raiders for
that very reason. Raiders are individuals or corporations that buy up large blocks of
shares in companies that they think are pursuing strategies that do not maximize wealth.
b.
Corporate raiders plan to take over and run the company themselves or to replace the top
management team with better strategists.
c.
If raiders succeed in their takeover bid, the new strategies they institute can create
millions of dollars of wealth for shareholders, including the raiders themselves.
d.
Even if the raiders do not succeed in the takeover, the defending company will often buy
back their shares just to be rid of them, paying a premium price. This practice is called
greenmail.
e.
The takeover constraint has not been invoked as frequently in the late 1990s and 2000s,
because of changed circumstances, such as the heavy debt acquired by many firms in
recent years, which makes firms less attractive as takeover targets. But takeovers tend to
run in cycles, and its likely another cycle will come around someday.
f.
The takeover constraint is the last resort, used only when all other forms of corporate
governance have failed.
When agency relationships exist within a company, such as between supervisor and
subordinate, strategic control mechanisms better align the interests of top managers and
employees.
a.
Strategic control mechanisms are the primary mechanism of internal governance. These
systems consist of the formal goal setting, measurement, and feedback systems that allow
managers to evaluate the effectiveness of their firms strategy.
b.
The process requires top managers to establish standards, create a system for periodic
measurement, compare actual performance to the standards, and evaluate results.
c.
These steps ensure that lower-level managers, as the agent of top managers, are acting in
the best interests of top managers.
Show Transparency 70
Figure 11.4: A Balanced Scorecard Approach
d.

The balanced scorecard approach to strategic control asks top managers to evaluate
performance on efficiency, quality, innovation, and responsiveness to customers, in
addition to the financial information used in traditional strategic control systems. The
additional information focuses on future performance, whereas financial information
relates to decisions and actions that were taken in the past.
(1) Measures of efficiency include production costs, raw materials costs, and number
of labor hours needed to make a product.
(2) Measures of quality include the reject rate, the rate of returns of defective items
from customers, and the product reliability over time.
(3) Measures of innovation include the number of new products introduced, the time
taken to develop a product, and the revenues generated from new products.
(4) Measures of responsiveness to customers include the number of repeat customers,
on-time delivery rates, and level of customer service.
e.
Reliance on several different types of measures, rather than just financial measures,
makes the balanced scorecard approach more accurate and useful to managers.
6.
Another mechanism for aligning the interests of lower-level managers with that of top managers
involves the use of employee incentives to motivate employees to work towards goals focused
on maximizing profitability.
a.
Employee stock ownership plans and stock option grants can be effective tools, especially
if employees at lower levels of the organization are included.
b.
Another approach is to tie employee compensation to the attainment of strategic goals, as
is commonly done with bonus pay.
VII. Ethics and Strategy
A. Ethics is another important consideration as managers make and implement strategic decisions. An
ethical decision is one that reasonable stakeholders would find acceptable because it aids

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Chapter 11: Corporate Performance, Governance, and Business Ethics

B.
C.
D.

E.

stakeholders, the organization, or society. An unethical decision is a decision that managers would
prefer to disguise because it helps the company or an individual gain at the expense of society or other
stakeholders.
The purpose of business ethics is to give people tools for dealing with moral complexity. It does not
help people distinguish right from wrong. Most people know the difference between right and wrong,
and they act on that information in their private lives, but fail to do so in their professional lives.
Business ethics emphasizes two points. First, that business decisions have an ethical component, and
second, that managers must consider the ethical implications of strategic decision before choosing a
course of action.
An important first step is for companies to establish an organizational climate that emphasizes the
importance of ethics.
1.
Top managers must use their leadership position to incorporate an ethical dimension into the
values they stress.
2.
Ethical values must be incorporated into the companys mission statement.
3.
Ethical values must be acted on, and should affect hiring, firing, and incentive systems to
reward adherence to ethical values.
Another important action is to give managers a clear, consistent, systematic way to think about ethical
issues.
1.
The various ways to answer the question What is ethical? can be understood through the use
of three models: the utilitarian, moral rights, and justice models. The principles of each are
summarized in Table 11.2.
a.
The utilitarian perspective asserts that an ethical decision is one that does the most good
for the most people.
b.
The moral rights perspective asserts that an ethical decision is one that does not violate
the rights of any stakeholders.
c.
The justice perspective asserts that an ethical decision is one that distributes benefits and
harms across stakeholder groups in a fair or impartial way.
2.
Another way to decide whether a decision or behavior is ethical is to examine the three
questions below. If one can answer yes to all three, then the decision or behavior is probably
acceptable.
a.
Does my decision fall within the accepted values or standards that typically apply in the
organizational environment?
b.
Am I willing to see the decision communicated to all stakeholders affected by itfor
example, by having it reported in newspapers or on television?
c.
Would the people with whom I have a significant personal relationship, such as family
members, friends, or even managers in other organizations, approve of the decision?
3.
Yet another approach is to work through a four-step process.
a.
First, managers should identify which stakeholders are affected by the decision and in
what ways, paying close attention to the possibility of violating stakeholders rights.
b.
Then the manager should judge the ethics of the proposed strategic decision using moral
principles.
c.
Next, the firm must establish moral intent, that is, must resolve to place moral concerns
ahead of any other concerns if stakeholders rights or moral principles have been violated.
d.
The final step is to implement the ethical decision or action.

ANSWERS TO DISCUSSION QUESTIONS

1.

How prevalent was the agency problem in corporate America during the late 1990s?
There have been a number of high-profile lawsuits that resulted from executive misconduct in the last
several years. Investors have lost confidence in corporate honesty and in auditors ability to rein in corporate
excesses, and this has been reflected in their defection from the stock market. The agency problem is
facilitated by information asymmetry, and the popular decentralized decision-making and empowerment
programs of the 1990s made it easier for workers to hide their actions from their superiors. In addition, as
the audit industry becomes more competitive and less profitable, auditors are increasingly reluctant to be
tough and risk losing a customer. Its impossible to know the true extent of the problem from outside, but
even highly respected firms such as GE have come under close scrutiny in this new era of investor paranoia.

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Chapter 11: Corporate Performance, Governance, and Business Ethics

2.

141

Who benefited the most from the late 1990s boom in initial public offerings of Internet companies:
investors (stockholders) in those companies, managers, or investment bankers?
All of these benefited to some extent, but in different ways. Stockholders who bought at the time of the
initial public offering (IPO) and sold when the stock was high, profited tremendously. Unfortunately,
however, the average investor who bought some time after the IPO when the stock value was already high,
and didnt sell until the price had fallen substantially made little money, or even experienced losses.
Managers, to the extent that they were stockholders, experienced the same risk-return relationship. Many
managers were among those who invested early, and therefore had a greater chance of profits, if they sold
before the drastic decline. Investment bankers made money primarily on fees for the IPOs, which are quite
steep. Fees are less risky than are stock investments, and therefore the bankers had a greater chance of
profiting from their participation in the IPOs.

3.

Why is maximizing return on invested capital consistent with maximizing returns to stockholders?
Stockholders profit most when companies focus on maximizing ROIC for three reasons. First, high
profitability leads to excess funds that can then be used to pay dividends, increasing stockholder wealth.
Second, high profitability leads to excess funds available for long-term investment in growing the
corporation or improving its performance, which leads to a long-term appreciation in share value, increasing
stockholder wealth. Third, other investors see profitability and then buy more of that firms stock, driving
up the share value and increasing stockholder wealth.

4.

How might a company configure its strategy-making processes to reduce the probability that managers will
pursue their own self-interest, at the expense of stockholders?
In order to reduce the agency problem, firms must exercise appropriate and adequate control and
monitoring. In order to control the actions of top executives, the board of directors should be involved in
strategy-making at high levels, and should be charged with ensuring that the strategies chosen are in the
long-term interests of the firm. The board should also be given responsibility for overseeing the actions of
top managers to ensure that they are in fact implementing the chosen strategy. The board should be
composed of mostly outside members representing any large stockholder groups.
Another governance mechanism is to use strategic controls to ensure that lower-level managers act in
agreement with the wishes of top managers. This process requires top managers to establish standards,
create a system for periodic measurement, compare actual performance to the standards, and evaluate
results. In order to implement this system, there must be some centralization; highly decentralized
organizations do not provide adequate opportunities for oversight, and the resulting information asymmetry
can lead to the agency problem.

5.

Should stock options be treated as an expense? If they were, what impact would this have on a company?
Answers will vary, but it should be noted that treating stock options as an expense is helpful to stockholders
in evaluating the true financial position of a firm. Some of the savviest investors, such as Warren Buffet,
CEO of Berkshire Hathaway, insist that firms treat stock options as expenses when they evaluate the firms
worth. The short-term impact would be lower profitability, however, some feel that the resulting increase in
stockholder confidence might cause share prices to rise anyway. The long-term impact is that companies
would be more cautious in offering stock options, knowing that they would be fully disclosed. Whether
stock options are helpful to firmsbecause they align the interests of managers and stockholdersor
whether they have been exploited unethically and are not useful, is a subject open to debate.

SMALL-GROUP EXERCISE: EVALUATING STAKEHOLDER CLAIMS

Students are asked to break into small groups and identify the stakeholders of their school. They are asked to
describe the claims the stakeholders put on the organization, to show how the school is responding to their claims,
and make suggestions for improving the schools strategy with regards to various stakeholder groups. Students
also should prioritize the claims of various stakeholder groups on the institution and decide which claims should
take precedence.
Teaching Note: Students are likely to see the needs of students as most important, but you should also point out
the contributions that are made by groups such as faculty, staff, benefactors, funding agencies, the local

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Chapter 11: Corporate Performance, Governance, and Business Ethics

community, and corporate sponsors. One way to graphically illustrate for students the importance of a variety of
stakeholder groups is to show them how the schools expenses are paid: what proportion comes from tuition, from
alumni, from government agencies, and so on. You can also ask them to consider what would happen if they lost
support from one of these groups, for instance, if professors went on strike or the federal government quit offering
student loans.

ARTICLE FILE 11
Students must find a company that ran into trouble because it failed to take into account the rights of one of its
stakeholder groups when making an important strategic decision.
Teaching Note: In order to help students find examples, suggest that they look for some of the following types of
events as indicators of troubled stakeholder relationships: strikes, boycotts, dramatic sales losses, lawsuits,
regulatory actions, or any intensely negative publicity. Some examples that were current at the time this manual
was written include the withdrawing of legislative support from Amtrak, negative publicity surrounding
Consolidated Edisons cleanup of the Hudson River, and recent strikes at Boeing and Delta Dental. In class, ask
students to briefly describe some of the examples they found, and then ask the class to consider what could have
been done differently in order to satisfy multiple stakeholder groups.

STRATEGIC MANAGEMENT PROJECT: MODULE 11

Students are asked to identify their firms stakeholder groups, as well as what each group gives to and receives
from the firm. They then must evaluate the CEOs performance from the perspective of different stakeholder
groups. Next, students should evaluate the effectiveness of the firms governance mechanisms in aligning the
interests of managers and stockholders. Finally, the students are asked to consider the ethical implications of one
of the firms recent strategic decisions, and tell whether they believe the firm decided correctly from an ethical
standpoint.
Teaching Note: As students evaluate the CEOs performance, point out to them that different groups may evaluate
the same action in quite different ways, depending on the groups priorities and needs. In the same way, an ethical
evaluation may be done from different viewpoints and may result in quite different conclusions.

EXPLORING THE WEB: VISITING MERCK

Students are asked to visit Mercks web site (at www.merck.com, select About Merck and then Mission
Statement) to view the firms mission statement. They should examine the mission statement for a statement of
basic goals, guidelines for managerial action, and recognition of stakeholder claims. They are then asked to
discuss the firms stated interest in and success at balancing stockholders need for profitability against societys
need for beneficial and affordable medicines. In the General Task, they are asked to find an example of a firm in
which there was overt conflict between principals and agents about the future strategic direction of the firm.
Teaching Note: At the web site, students will find information that shows that Merck is pursuing goals related to
ethics, excellence in scientific research, diversity, and profitability, but they claim that their most important goal is
preserving and improving human life. The statement shows what actions are expected of managers, and it
recognizes the claims of stockholders, employees, customers, and society. This statement also emphasizes that
profits should only come as a result of work that benefits humanity. For an interesting classroom discussion,
obtain samples of several other mission statements and compare them to Mercks. Most of them give less
emphasis to benefiting societyask students why they think this is so. A cynical student may note that Merck is
under a tremendous political pressure to provide life-saving drugs to Third World countries at very low costs, and
thus the mission statement may be motivated by public relations to serve as corporate propaganda.
In the General Task, students should look for companies that have experienced an abrupt, unwelcome change in
top leadership, such as a sudden resignation. This is one clue that the relationship between managers and
principals has deteriorated, although there are many additional troubled relationships that have not yet reached
this conclusion. Recent examples include Skillings abrupt departure from Enron, Messiers departure from
Vivendi, and Waksals resignation from ImClone.

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Chapter 11: Corporate Performance, Governance, and Business Ethics

143

CLOSING CASE: CHAINSAW AL GETS THE AX

Small appliance maker, Sunbeam, hired Al Dunlap as CEO in 1996 in an effort to turn around financial
performance. Dunlaps new plan called for cutting the workforce in half, closing two-thirds of the firms factories,
and reducing products and divisions drastically. At the same time, he proposed increasing sales and innovation
within the companys remaining divisions. The company engaged in some inventory practices, that although legal
and approved by firm auditors Arthur Andersen, were seen as unethical by some. Dunlap made some related
acquisitions, but sales were low, leading to further executive firings and worker layoffs. When the stock price fell
and the board of directors met to discuss the firms problems, Dunlap threatened to resign immediately unless he
got the boards support. The directors investigated further, uncovering a very disgruntled workforce and likely
further losses. Dunlap was fired after serving less than two years as Sunbeams CEO.
Teaching Note: This case reiterates several of the key points from this chapter, including the need to attack the
underlying causes of poor performance, the importance of maintaining good relationships with key stakeholders,
appropriate mechanisms for corporate governance, and the role of ethics in determining a firms strategy.

Answers to Case Discussion Questions

1.

In whose best interests was Al Dunlap acting? Do you think he was honestly trying to discharge his
obligation to key stakeholder groups, such as stockholders, employees, and customers?
Dunlap seemed to be operating in a way that would increase and consolidate his power at Sunbeam,
including firing top managers and threatening the firms directors. His actions do not point to a strategy of
satisfying key stakeholder groups. For example, if Dunlap was truly concerned with the interests of
employees, he would probably not have downsized so drastically, he would not have fired top managers that
were respected and trusted by workers, he would not have blamed Sunbeams problems on his stupid
employees, and so on. In virtually every example mentioned in the case, Dunlaps actions benefited no one
but himself.

2.

Do you think the Sunbeam board exercised its fiduciary duty? What does this tell you about how boards can
work?
If his strategy had been successful, Dunlaps inappropriate methods might have been overlooked or dealt
with more softly. Instead, his aggressive methods, coupled with poor performance, apparently drove the
board to fire him. It seems, however, that the board did not exercise careful control over Dunlap in his early
days as CEO, probably because many of them were Dunlaps friends and had been appointed by him. It
took time for their initial trust in him to erode. This case demonstrates that boards act like many other small,
close-knit groupsthey tend to trust each other more than outsiders, they tend to think alike over time, and
they tend to stick together when problems arise.

3.

In retrospect, what might Al Dunlap have done differently to engineer a turnaround at Sunbeam?
Many of Dunlaps ideas were built upon solid foundations, but in carrying them to an extreme, their original
purpose was lost. For example, it does seem that Sunbeam had too many different product lines, and
therefore was losing focus. Simplifying product and division structure was probably a good idea. Also, there
were undoubtedly some ineffective top managers. Dunlap could have spent time evaluating each ones
performance, and then firing the least competent, rather than implementing a mass firing. Dunlap could
have moderated his response and implemented them in a more thoughtful way.
Also, Dunlap could have considered his personal benefit less, and the firms long-term interests more. If he
had done so, its likely that his strategy could have improved long-term financial performance. Then, his
rewards would have been even greater, and other stakeholders would have benefited also.

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