Wei Shi - Understanding and Managing Strategic Governance

In addition, choosing an outside versus an inside CEO (one who is currently employed at the firm) can lead to more strategic risk taking for the organization, but such increased risk taking can result in performance extremeness. 14 Increased strategic risk taking is analogous to swinging for the fence in baseball (trying to hit a home run). Although Babe Ruth set home run records, he also set record strikeouts at the plate. Appropriate executive compensation also influences risk taking. Too much emphasis on CEO stock options leads to excessive strategic risk taking and can lead to some good performance, though poor performance (striking out) is more likely. 15

A board of directors is a group of individuals elected by shareholders whose primary responsibility is to act in the best interests of stakeholders, particularly owners, by formally monitoring and controlling the firm's top-level managers. Board members reach their expected objectives by using their powers to set strategies and policies for the organization and reward and discipline top managers. The work of boards, though important to all shareholders, becomes especially important to a firm's individual shareholders with small ownership percentages since they depend heavily on the directors to represent their interests.

Unfortunately, evidence suggests that boards have not been highly effective in monitoring and controlling top-level managers' decisions and subsequent actions. 16 This problematic conclusion may be even more prevalent in emerging-market countries. However, large differences exist in the arrangement of governance systems between developed and emerging markets around the world. The Strategic Governance Highlight ( Box 1.2) provides an illustration of how boards conduct strategic governance in Europe, Japan, and China. Although insider-dominated boards still prevail in much of the world, the trend is changing, especially in developed countries like Germany and Japan, but also in emerging market countries like China.

As noted earlier, among emerging countries and historically in the United States, inside managers dominate boards of directors. Yet, we concur with the widely accepted view that a board with a significant percentage of its membership composed of the firm's top-level managers provides relatively weak monitoring and control of managerial decisions. Under such a board, managers sometimes use their power to select and compensate directors and exploit their personal ties to implement strategies that favor executive interests. In 1984, in response to this concern, the New York Stock Exchange (NYSE) implemented a rule requiring outside directors to head the audit committee. Subsequently, after the SOX Act was passed in 2002, other new rules required that independent outside directors lead important committees, such as the audit, compensation, and nominating and governance committees. Policies of the NYSE now require companies to maintain boards of directors that are composed of a majority of outside independent directors, as well as to maintain fully independent audit committees.

But while the additional scrutiny of corporate governance practices has led boards to devote significant attention to recruiting quality independent directors, 17 the emphasis on outside directors has led to 40 percent of boards having only one inside manager on the board: the CEO. This scenario produces another less-than-ideal dynamic that leads to less monitoring of executive decisions by the board, 18 since monitoring becomes more focused on financial control rather than strategic control, especially without sufficient insider managers to properly inform the outside members about the intricacies of long-term strategic decisions and how they are implemented. 19 In fact, such boards (with the CEO as the only insider) pay the chief executive excessively, have more instances of financial misconduct, and have lower performance than boards with more than one insider. 20 Boards should seek balance to be sufficiently knowledgeable and achieve the most effective approach to fulfilling their purpose over time in representing stakeholder interests. Next, we take a closer look at board characteristics, monitoring, and setting executive compensation to further understand strategic governance.

Corporate governance is of concern to individual firms as well as nations. Although corporate governance reflects company standards, it also collectively reflects the societal standards of countries. Standards are changing, even in emerging economies, such as in the level of independence of board members to enact practices for effective oversight of a firm's internal control efforts. Since firm leaders seek to invest in countries with national governance standards that are acceptable to them, especially when expanding geographically into emerging markets, national governments pay attention to corporate governance.

German firms with more than 2,000 employees are required to have a two-tiered board structure that places the responsibility of monitoring and controlling managerial (or supervisory) decisions and actions in the hands of a separate group. All the functions of strategy and management are the responsibility of the management board. However, appointment to management falls under the responsibility of the supervisory tier, while employees, union members, and shareholders appoint members to this supervisory tier. Proponents of the German structure suggest that it helps prevent corporate wrongdoing and rash decisions by “dictatorial CEOs,” making the board more stakeholder- versus shareholder-dominant. However, critics maintain that the structure slows decision-making and often ties a CEO's hands during strategy development and implementation. The corporate governance practices in Germany makes it difficult to restructure companies as quickly as in the US. Also, because of the role of local government (through the board structure) and the power of banks in Germany's corporate governance structure, private shareholders rarely have major ownership positions in German firms.

As in Germany, banks in Japan have an important role in financing and monitoring large public firms. Because the main bank in a keiretsu (a group of firms tied together by cross-shareholdings) owns a large share position and holds a large amount of corporate debt, it has the closest relationship with a firm's top-level managers. The main bank managers provide financial advice to firm leaders and also closely monitor managers, although they have become less significant in fostering corporate restructuring. Japanese firms are also concerned with a broader set of stakeholders than are firms in the US, including employees, suppliers, and customers, because of their group ties. Moreover, a keiretsu is more than an economic concept—it, too, is a family-like network. Some believe, though, that extensive cross-shareholdings impede the type of structural change that is needed to improve the nation's corporate governance practices. However, recent changes in the governance code in Japan have been fostering better opportunities for improved shareholder monitoring.

China has a unique and large economy, mixed with both socialist and market-oriented traits. Over time, the government has done much to improve the corporate governance of listed companies, particularly in light of increasing privatization of businesses and the development of equity markets. However, the stock markets in China remain young and in development. In their early years, these markets were weak because of significant insider trading, but with stronger governance, they have improved. There has been a gradual decline in the equity held in state-owned enterprises while the number and percentage of private firms have grown, but the state still relies on direct and/or indirect controls to influence the strategies that firms employ. Even private firms try to develop political ties with government officials because of their role in providing access to resources and to the economy. Political governance—control mechanisms used by political actors to achieve their political objectives—permeates listed firms in China. In fact, oftentimes political governance supersedes corporate governance. At times, executives and boards must satisfy government-mandated social goals above maximizing shareholder returns. Such a model sets up potential conflicts between the owners, particularly between the state owner and the private equity owners of such enterprises.