The Sarbanes – Oxley Act

Description

Text:

Title: Strategic Management and Business Policy Globalization, Innovation, and Sustainability, 15th edition Authors:

Thomas L. Wheelen and J. David Hunger, Alan Hoffman, Charles Bamford.

Publisher: Pearson

ISBN: 978-0-13-452215-9

Read:

Chapter 2 and 3.

Question:

The Sarbanes – Oxley Act was passed in June of 2002. Research the significance of the legislation.

Explain why it was passed and its importance. Consider how you as the CEO of a corporation would use this knowledge to organize and improve the corporate governance inside your company.

Requirements

All source’s must be properly cited. The paper must be submitted in APA format.

In text citation

minimum 2500-words

Unformatted Attachment Preview

Chapter
2
Corporate
Governance
Environmental
Scanning:
Strategy
Formulation:
Strategy
Implementation:
Evaluation
and Control:
Gathering
Information
Developing
Long-range Plans
Putting Strategy
into Action
Monitoring
Performance
External
Mission
Natural
Environment:
Reason for
existence
Resources and
climate
Societal
Environment:
Objectives
What
results to
accomplish
by when
General forces
Task
Environment:
Industry analysis
Strategies
Plan to
achieve the
mission &
objectives
Policies
Broad
guidelines
for decision
making
Internal
Programs
and Tactics
Activities
needed to
accomplish
a plan
Budgets
Cost of the
programs
Procedures
Sequence
of steps
needed to
do the job
Structure:
Chain of command
Culture:
Performance
Actual results
Beliefs, expectations,
values
Resources:
Assets, skills,
competencies,
knowledge
Feedback/Learning: Make corrections as needed
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72
Learning Objectives
After reading this chapter, you should be able to:
2-1. Describe the role and responsibilities
of the board of directors in corporate
governance
2-2. Explain how the composition of a board
can affect its operation
2-3. Describe the impact of the Sarbanes–
Oxley Act on corporate governance in the
United States
2-4. Discuss trends in corporate governance
2-5. Explain how executive leadership is an
important part of strategic management
Disarray with the HP Board of Directors
Sometimes an activist or even catalyst board does more harm than good.
This has certainly been the case at Hewlett-Packard Company, the Palo
Alto pioneer in technology.
Lewis Platt was only the fourth CEO in the history of the company,
and like his predecessor (John A. Young); he was a long-time engineering
employee of the company. Under his leadership, the company prospered as
it had through most of its 50-year history up to that point. With the support of
the board, he spun off the Medical Instruments division and made tentative moves
toward the new information age, but was slow to recognize the importance of the Internet.
In 1999, along with the board of directors, he decided to look outside the company for the first time and
try to hire a visible, passionate leader for the staid engineering-oriented firm. On July 19, 1999, HP announced
that Carly Fiorina would be the new CEO, making her the first woman to head a DOW 30 company. Fiorina made
her name at Lucent Technologies where she was President of a company that made a remarkable turnaround
in the face of the huge changes in technology of the day.
Some of the same board members that hired her then turned against her in one of the most public proxy
battles of our times when she announced a US$25 billion merger with Compaq Computer Company in September
2001. Walter Hewlett and Lewis Platt openly opposed the merger. The plan to move HP into an innovation
machine in the Internet age was now being sidelined to put most of its resources in a low-margin, shrinking PC
manufacturing business. Wall Street hated the idea. HP stock lost 18% of its value on the day the merger was
announced and many analysts in the industry thought this was a bad move. Fiorina forced the merger forward
with the support of the majority of the board of directors.
On February 22, 2002, the HP Board of Directors sent a very public and stinging letter of criticism against
Walter Hewlett to all of its shareholders. Hewlett responded by taking out ads in major newspapers opposing
the acquisition. In the end, the merger was approved, but by only a scant 3% majority.
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The history of acquisitions is not a good one. Very few bring real value to the companies that are the acquirer. The bigger the acquisition, the more likely this is the case. Such
was the fate of HP. By the end of 2004, the board was fed up with Carly Fiorina’s inability
to move the new, huge HP forward. The board began meeting in private without their
high-profile CEO. On February 6, 2005, the board met with Fiorina at Chicago’s O’Hare
Hyatt Hotel and expressed their frustration with her leadership and her unwillingness to
work with the board of directors on the future of the company. The next day they asked
her to resign.
Believing that it was a failure of execution, the board moved to hire someone with
strict operating credentials. The result was Mark Hurd, the 25-year veteran CEO at NCR
Corporation. Hurd roared into the company, eliminating 15,000+ jobs, cutting R&D, and
attempting to automate consulting services. A leak of information discussed at a board of
director’s strategy meeting in late 2005 led then–Board Chairman Patricia Dunn and CEO
Mark Hurd to initiate an investigation of fellow board members. Using detectives who
posed as reporters, they obtained phone records of those people on the board that they
suspected, and the spying scandal exploded into the open.
Dunn was fired from her board seat in 2006 and Newsweek magazine put her on the
cover with the title “The Boss Who Spied on Her Board.” Mark Hurd escaped any serious
repercussions from the scandal and announced a new, very strict code of conduct for the
corporation.
By all accounts, Mark Hurd was successful at turning the company around and was
listed as one of the best CEOs in 2009. However, another scandal broke, Hurd was accused
of sexual harassment with an HP marketing consultant. While the board found that he
did not actually violate the company’s sexual-harassment policies, they did find that he
submitted inaccurate expense reports intended to conceal the relationship. He was forced
to resign in August 2010 by a powerful but small group of directors.
In the wake of the Hurd resignation, there was a major board shakeup. Four directors
involved in forcing the Hurd resignation resigned their board seats and five new board
members were named. In November, 2010, the board named Leo Apotheker as the new
CEO. He was the former head of Global Field Operations at SAP, and would remain the
company’s CEO for little more than 10 months.
Apotheker’s move to push forward the HP TouchPad tablet was a commercial failure at the same time that HP phones were taking a beating in the market. In a stunning announcement in September 2011, he stated that HP would exit the PC business
entirely. HP was the leader in PC sales both within the United States and globally. The
outrage was immediate and overwhelming. The company reversed position two weeks
later, but the board was appalled at his lack of leadership. After firing Apotheker,
the board named one of its own members, former eBay CEO Meg Whitman to run the
company.
The board turmoil did not end. After a contentious annual meeting in 2013, the
Chairman of the Board stepped down and two other board members resigned. In 2014
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Meg Whitman was named Chairman of the Board and two new members were added
at the same time that the company was in the process of the most significant layoffs
in its history. From 2011 when Whitman took over as CEO to 2015, the company laid
off more than 55,000 employees. Effective November 1, 2015 the company split into
two publically traded companies in an effort to separate the slow growing PC and
printer business from the potentially fast growing cloud technology and cyber security
businesses.
One of the most important responsibilities that a board of directors has is to effectively recruit and work with management to lead the business. The CEO revolving door
at HP has cost the company more than US$83 million in severance pay for CEOs that the
board no longer wants to run the company. CNN Money reported in 2012 that “Before
Apotheker ever came to HP, the company was known for its fractious board. Individual
directors would cycle in and out, yet somehow the group seemed constantly divided by
personal rivalries, bickering, and leaks to the press.”
SOURCES: “HP’s Meg Whitman: More Job Cuts Ahead,” CNN Money, June 4, 2015. (money.
cnn.com/2015/06/04/news/economy/hp-job-cuts-meg-whitman.index.html accessed January,
2016.), “HP Announces Changes to Board of Directors,” Yahoo Finance, April 4, 2013. (finance.
yahoo.com/news/hp-announces-changes-board-directors-203303763.html), “HP Announces
Changes to Its Board of Directors,” MarketWatch, July 17, 2014. (www.marketwatch.com/sotry
/hp-announces-changes-to-its-board-of-directors-2014-01-17), Bandler, J. and Burke, D. “How
Hewlett-Packard Lost Its Way,” Accessed 5/30/13, www.tech.fortune.cnn.com/2012/05/08
/500-hp-apotheker/ (accessed January, 2016); Lohr, S. “Lewis E. Platt, 64, Chief of Hewlett-Packard
in 1990’s Dies,” nytimes.com, Accessed 5/30/13, www.nytimes.com/2005/09/10
/technology/10platt.html; Stanford Graduate School of Business Case SM-130. “HP and Compaq Combined: In Search of Scale and Scope,” Accessed 5/30/13, www.cendix.com/downloads/education/HP%20
Compaq.pdf; Elgin, B. “The Inside Story of Carly’s Ouster,” Accessed 5/30/13, www.businessweek.com/
stories/2005-02-20/the-inside-story-of-carlys-ouster; Oracle.com, “Mark Hurd – President,” Accessed,
5/30/13, www.oracle.com/us/corporate/press/executives/mark-hurd-170533.html (accessed January,
2016); Gregory, S. “Corporate Scandals: Why HP had to Oust Mark Hurd,” Accessed 5/30/13, www.
time.com/time/business/article/0,8599,2009617,00.html; Arnold, L. and Turner, N. “Patricia Dunn, HP
Chairman Fired in Spying Scandal, Dies at 58,” Accessed 5/30/13, www.businessweek.com/news/201112-05/patricia-dunn-hp-chairman-fired-in-spying-scandal-dies-at-58.html (accessed January, 2016).
Role of the Board of Directors
2-1. Describe the role
and responsibilities
of the board of
directors in corporate
governance
A corporation is a mechanism established to allow different parties to contribute capital, expertise, and labor for their mutual benefit. The investor/shareholder participates
in the profits (in the form of dividends and stock price increases) of the enterprise
without taking responsibility for the operations. Management runs the company without being responsible for personally providing the funds. To make this possible, laws
have been passed that give shareholders limited liability and, correspondingly, limited
involvement in a corporation’s activities. That involvement does include, however, the
right to elect directors who have a legal duty to represent the shareholders and protect
their interests. As representatives of the shareholders, directors have both the authority and the responsibility to establish basic corporate policies and to ensure that they
are followed.1
The board of directors, therefore, has an obligation to approve all decisions that
might affect the long-term performance of the corporation. This means that the corporation is fundamentally governed by the board of directors overseeing top management,
with the concurrence of the shareholder. The term corporate governance refers to the
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relationship among these three groups in determining the direction and performance
of the corporation.2
Increasingly, shareholders, activist investors, and various interest groups have
seriously questioned the role of the board of directors in corporations. They are concerned that inside board members may use their position to feather their own nests
and that outside board members often lack sufficient knowledge, involvement, and
enthusiasm to do an adequate job of monitoring and providing guidance to top management. Instances of widespread corruption and questionable accounting practices at
Enron, Global Crossing, WorldCom, Tyco, Bernard L. Madoff Investment Securities,
and Qwest, among others, seem to justify their concerns. The board at HP appeared to
be incapable of deciding upon the direction of the business, moving CEOs in and out
as its ideas changed.
The general public has not only become more aware and more critical of many
boards’ apparent lack of responsibility for corporate activities, it has begun to push
government to demand accountability. As a result, the board as a rubber stamp of the
CEO or as a bastion of the “old-boy” selection system is slowly being replaced by more
active, more professional boards.
RESPONSIBILITIES OF THE BOARD
Laws and standards defining the responsibilities of boards of directors vary from country to country. For example, board members in Ontario, Canada, face more than 100
provincial and federal laws governing director liability. The United States, however,
has no clear national standards or federal laws. Specific requirements of directors vary,
depending on the state in which the corporate charter is issued. There is, nevertheless,
a developing worldwide consensus concerning the major responsibilities of a board. An
article by Spencer Stuart written by an international team of contributors suggested the
following five board of director responsibilities:
1. Effective board leadership including the processes, makeup, and output of the board
2. Strategy of the organization
3. Risk vs. initiative and the overall risk profile of the organization
4. Succession planning for the board and top management team
5. Sustainability3
These suggested responsibilities are in agreement with a survey by the National
Association of Corporate Directors, in which U.S. CEOs reported that the four most
important issues boards should address are corporate performance, CEO succession,
strategic planning, and corporate governance.4 Directors in the United States must
make certain, in addition to the duties just listed, that the corporation is managed in
accordance with the laws of the state in which it is incorporated. Because more than
half of all publicly traded companies in the United States are incorporated in the state
of Delaware, this state’s laws and rulings have more impact than do those of any other
state.5 Directors must also ensure management’s adherence to laws and regulations,
such as those dealing with the issuance of securities, insider trading, and other conflictof-interest situations. They must also be aware of the needs and demands of constituent
groups so that they can achieve a judicious balance among the interests of these diverse
groups while ensuring the continued functioning of the corporation.
In a legal sense, the board is required to direct the affairs of the corporation but
not to manage them. It is charged by law to act with due care. If a director or the board
as a whole fails to act with due care and, as a result, the corporation is in some way
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harmed, the careless director or directors can be held personally liable for the harm
done. This is no small concern given that one survey of outside directors revealed that
more than 40% had been named as part of lawsuits against corporations.6 In 2015 the
courts ruled that shareholders could pursue claims against Zynga (Farmville and Words
with Friends among many others). Based upon the testimony of at least a half-dozen
confidential witnesses, it appears that Zynga management intended to hide information
detrimental to the price of the stock. Shareholders claim that insiders (Members of the
Senior Management Team and Board of Directors) were allowed to sell $593 million
in stock before a post-IPO lockup was to expire. The stock dropped 75% over the next
four months as declining user activity information was released.7 Most corporations
have found that they need directors’ and officers’ liability insurance in order to attract
people to become members of boards of directors.
McKinsey & Company began surveying the board of directors about their understanding of company issues in 2011. Their latest survey results revealed the following
statistics about board members who felt they had a complete or a good understanding
of the following: 8
■
■
■
■
■
Financial Position – 91%
Current Strategy – 87%
Value Creation – 74%
Industry Dynamics – 77%
Risks the company faces – 69%
In addition, 73% now report that they believe they have a high or very high impact
on company financial success.
Role of the Board in Strategic Management
How does a board of directors fulfill their many responsibilities? The role of the board
of directors in strategic management is to carry out three basic tasks:
■
■
■
Monitor: By acting through its committees, a board can keep abreast of developments inside and outside the corporation, bringing to management’s attention
developments it might have overlooked. A board should, at the minimum, carry
out this task.
Evaluate and influence: A board can examine management’s proposals, decisions,
and actions; agree or disagree with them; give advice and offer suggestions; and
outline alternatives. More active boards perform this task in addition to monitoring.
Initiate and determine: A board can delineate a corporation’s mission and specify
strategic options to its management. Only the most active boards take on this task
in addition to the two previous ones.
Board of Directors’ Continuum
A board of directors is involved in strategic management to the extent that it carries out
the three tasks of monitoring, evaluating and influencing, and initiating and determining. The board of directors’ continuum shown in Figure 2–1 shows the possible degree
of involvement (from low to high) in the strategic management process. Boards can
range from phantom boards with no real involvement to catalyst boards with a very
high degree of involvement.9 Research suggests that active board involvement in strategic management is positively related to a corporation’s financial performance and its
credit rating.10
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Figure 2–1
Board of Directors’ Continuum
DEGREE OF INVOLVEMENT IN STRATEGIC MANAGEMENT
Low
(Passive)
Phantom
Never knows
what to do, if
anything; no
degree of
involvement.
High
(Active)
Rubber
Stamp
Minimal
Review
Nominal
Participation
Active
Participation
Permits officers
to make all
decisions. It
votes as the
officers recommend on action
issues.
Formally reviews
selected issues
that officers
bring to its
attention.
Involved to a
limited degree
in the performance or review
of selected key
decisions,
indicators, or
programs of
management.
Approves,
questions, and
makes final decisions on mission, strategy,
policies, and
objectives. Has
active board
committees.
Performs fiscal
and management audits.
Catalyst
Takes the
leading role in
establishing
and modifying
the mission,
objectives,
strategy, and
policies. It has
a very active
strategy
committee.
SOURCE: T. L. Wheelen and J. D. Hunger, “Board of Directors’ Continuum,” Copyright © 1994 by Wheelen and
Hunger Associates. Reprinted by permission.
Highly involved boards tend to be very active. They take their tasks of monitoring, evaluating and influencing, and initiating and determining very seriously;
they provide advice when necessary and keep management alert. As depicted in
Figure 2–1, their heavy involvement in the strategic management process places them
in the active participation or even catalyst positions. Although 74% of public corporations have periodic board meetings devoted primarily to the review of overall
company strategy, the boards may not have had much influence in generating the
plan itself.11 The same global survey of directors by McKinsey & Company found that
directors devote more time to strategy than any other area. Those boards reporting
high influence typically shared a common plan for creating value and had healthy
debate about what actions the company should take to create value. Together with
top management, these high-influence boards considered global trends and future
scenarios and developed plans. In contrast, those boards with low influence tended
not to do any of these things.12 Nevertheless, studies indicate that boards are becoming increasingly active.
These and other studies suggest that most large publicly owned corporations have
boards that operate at some point between nominal and active participation. As a board
becomes less involved in the affairs of the corporation, it moves farther to the left
on the continuum (see Figure 2–1). On the far left are passive phantom or rubberstamp boards that typically never initiate or determine strategy unless a crisis occurs. In
these situations, the CEO who also usually serves as Chairman of the Board (although
we see the same situation in active boards), personally nominates all directors and
works to keep board members under his or her control by giving them the “mushroom
treatment”—throw manure on them and keep them in the dark!
Generally, the smaller the corporation, the less active is its board of directors in
strategic management.13 In an entrepreneurial venture, for example, the privately held
corporation may be 100% owned by the founders—who also manage the company.
In this case, there is no need for an active board to protect the interests of the ownermanager shareholders—the interests of the owners and the managers are identical.
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In this instance, a board is really unnecessary and only meets to satisfy legal requirements. If stock is sold to outsiders to finance growth, however, the board becomes more
active. Key investors want seats on the board so they can oversee their investment. To
the extent that they still control most of the stock, however, the founders dominate the
board. Friends, family members, and key shareholders usually become members, but
the board acts primarily as a rubber stamp for any proposals put forward by the ownermanagers. In this type of company, the founder tends to be both CEO and Chairman
of the Board and the board includes few people who are not affiliated with the firm or
family.14 This cozy relationship between the board and management should change,
however, when the corporation goes public and stock is more widely dispersed. The
founders, who are still acting as management, may sometimes make decisions that conflict with the needs of the other shareholders (especially if the founders own less than
50% of the common stock). In this instance, problems could occur if the board fails to
become more active in terms of its roles and responsibilities. This situation can occur
in large organizations as well. Even after the high-profile IPO, Facebook was still more
than 50% controlled by founder Mark Zuckerberg and he used his position to make
significant strategic decisions without input from the board of directors. In 2012, just
ahead of the IPO of Facebook, he bought Instagram for roughly US$1 billion and only
then informed the board of his move.15
Board of Directors Composition
2-2. Explain how the
composition of a
board can affect its
operation
The boards of most publicly owned corporations are composed of both inside and outside directors. Inside directors (sometimes called management directors) are typically
officers or executives employed by the corporation. Outside directors (sometimes called
non-management directors) may be executives of other firms but are not employees of
the board’s corporation. Although there is yet no clear evidence indicating that a high
proportion of outsiders on a board results in improved financial performance,16 there
is a trend in the United States to increase the number of outsiders on boards and to
reduce the total size of the board.17 The board of directors of a typical large U.S. corporation has an average of 10 directors, 2 of whom are insiders.18 In 1998 there were no
non-executives (outside directors) that served as Chairman of the Board for the S&P
500 companies. By 2012 these outsiders comprised 23% of the Chair positions. Not
surprisingly, in 1998 84% of the S&P 500 companies had their CEO in a dual role as
Chairman. By 2012 that number had dropped to 56%.19
Outsiders thus account for 80% of the board members in large U.S. corporations
(approximately the same as in Canada). Boards in the United Kingdom typically have
5 inside and 5 outside directors, whereas in France boards usually consist of 3 insiders
and 8 outsiders. Japanese boards, in contrast, contain 2 outsiders and 12 insiders.20 The
board of directors in a typical small U.S. corporation has 4 to 5 members, of whom only
1 or 2 are outsiders.21 Research from large and small corporations reveals a negative
relationship between board size and firm profitability.22
People who favor a high proportion of outsiders state that outside directors are
less biased and more likely to evaluate management’s performance objectively than
are inside directors. This is the main reason why the U.S. Securities and Exchange
Commission (SEC) in 2003 required that a majority of directors on the board be independent outsiders. The SEC also required that all listed companies staff their audit,
compensation, and nominating/corporate governance committees entirely with independent, outside members. This view is in agreement with agency theory, which states
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INNOVATION issue
JCPENNEY AND INNOVATION
ron Johnson joined erstwhile retailer JCpenney
in November 2011 with a
mandate from the board of
directors to shake up the
organization. the board members
were not interested in another decade of classic retailer
wisdom, they wanted someone who would create a
new JCpenney. they got exactly what they were looking
for. the question was whether that bold move would
allow the company to thrive, limp along, or go out of
business.
Johnson was the architect behind the “cheap chic”
approach at target before he moved to apple with the
mandate to create “the” store experience. he designed
an apple retail approach that is the envy of the retailer
world and in the process created the world’s most profitable stores. Johnson was personally recruited to take over
JCpenney by Bill ackman. his company (pershing Square
Capital Management) owned 18% of JCpenney.
Johnson’s vision was to create a company that was not
dependent upon sales coupons or continuous promotions
for its survival. he joined a 110-year-old company that was
running 590 different promotions a year that cost the company (in promotion costs alone) more than US$1 billion.
Ninety-nine percent of those promotions were ignored by
their primary customer group. the real sales price for virtually every product in the store was substantially less than
the list price on the shelf.
the fundamental strategic approach was conceptually
sound. he was separating the company from its competitors and doing so with an approach that was rare in the
retailing world, durable as long as the competitors didn’t
believe that approach would work, and might have been
valuable for the company both from a cost containment
approach as well as its potential to draw in new customers. Unfortunately for JCpenny the story was over almost
before it began. Sales plummeted, profits evaporated,
and after 18 months on the job, Johnson was fired only
to be replaced by the former CeO of the company. perhaps Johnson’s biggest failure was rollout. rather than
experimenting with the new concept to refine the effort,
he demanded that it be put in place systemwide. he had
the support of the board until his unwillingness to compromise or reevaluate his strategy drove the board to act.
SOUrCeS: Berfield, S. and Maheshwari, S. 2012. “J.C. penney
vs. the Bargain hunters,” Bloomberg BusinessWeek, May 28–
June 3, 2012, pp. 21–22. rooney, J. “JCpenney’s New Strategy a tough Sell on the Sales Floor,” Forbes.com, accessed
5/30/13, www.forbes.com/sites/jenniferrooney/2012/03/14
/jc-penneys-new-strategy-a-tough-sell-on-the-sales-floor/
that problems arise in corporations because the agents (top management) are not
willing to bear responsibility for their decisions unless they own a substantial amount
of stock in the corporation. The theory suggests that a majority of a board needs to be
from outside the firm so that top management is prevented from acting selfishly to the
detriment of the shareholders. For example, proponents of agency theory argue that
managers in management-controlled firms (contrasted with owner-controlled firms in
which the founder or family still own a significant amount of stock) select less risky
strategies with quick payoffs in order to keep their jobs.23 This view is supported by
research revealing that manager-controlled firms (with weak boards) are more likely to
go into debt to diversify into unrelated markets (thus quickly boosting sales and assets
to justify higher salaries for themselves). These actions result in poorer long-term
performance than would be seen with owner-controlled firms.24 Boards with a larger
proportion of outside directors tend to favor growth through international expansion
and innovative venturing activities than do boards with a smaller proportion of outsiders.25 Outsiders tend to be more objective and critical of corporate activities. For
example, research reveals that the likelihood of a firm engaging in illegal behavior or
being sued declines with the addition of outsiders on the board.26 Research on family businesses has found that boards with a larger number of outsiders on the board
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tended to have better corporate governance and better performance than did boards
with fewer outsiders.27
In contrast, those who prefer inside over outside directors contend that outside
directors are less effective than are insiders because the outsiders are less likely to
have the necessary interest, availability, or competency. Stewardship theory proposes
that, because of their long tenure with the corporation, insiders (senior executives)
tend to identify with the corporation and its success. Rather than use the firm for their
own ends, these executives are thus most interested in guaranteeing the continued life
and success of the corporation. (See the Strategy Highlight feature for a discussion of
agency theory contrasted with stewardship theory.) Excluding all insiders but the CEO
reduces the opportunity for outside directors to see potential successors in action or
to obtain alternate points of view of management decisions. Outside directors may
sometimes serve on so many boards that they spread their time and interest too thin
STRATEGY highlight
AGENCY THEORY VERSUS STEWARDSHIP THEORY
IN CORPORATE GOVERNANCE
Managers of large, modern,
publicly held corporations
are typically not the owners.
In fact, most of today’s top managers own only nominal amounts of
stock in the corporation they manage. the real owners
(shareholders) elect boards of directors who hire managers as their agents to run the firm’s day-to-day activities.
Once hired, how trustworthy are these executives? Do they
put themselves or the firm first? there are two significant
schools of thought on this.
Agency Theory. as suggested in the classic study by Berle
and Means, top managers are, in effect, “hired hands”
who are very likely more interested in their personal welfare than that of the shareholders. For example, management might emphasize strategies, such as acquisitions, that
increase the size of the firm (to become more powerful and
to demand increased pay and benefits) or that diversify the
firm into unrelated businesses (to reduce short-term risk
and to allow them to put less effort into a core product line
that may be facing difficulty) but that result in a reduction
of dividends and/or stock price.
agency theory is concerned with analyzing and resolving
two problems that occur in relationships between principals
(owners/shareholders) and their agents (top management):
1. Conflict of interest arises when the desires or objectives of the owners and the agents conflict. For example, attitudes toward risk may be quite different.
agents may shy away from riskier strategies in order
to protect their jobs.
2. Moral hazard refers to the situation where it is difficult or expensive for the owners to verify what the
agents are actually doing.
according to agency theory, the likelihood that these
problems will occur increases when stock is widely held
(that is, when no one shareholder owns more than a small
percentage of the total common stock), when the board
of directors is composed of people who know little of the
company or who are personal friends of top management,
and when a high percentage of board members are inside
(management) directors.
to better align the interests of the agents with those of
the owners and to increase the corporation’s overall performance, agency theory suggests that top management have
a significant de