Explain uber's business model and deduce its strategic intent

12.1 The Shared Value Creation Framework

LO 12-1

Describe the shared value creation framework and its relationship to competitive advantage.

The shared value creation framework provides guidance to managers about how to reconcile the economic imperative of gaining and sustaining competitive advantage with corporate social responsibility (introduced in Chapter 2 ). 5 It helps managers create a larger pie that benefits both shareholders and other stakeholders. To develop the shared value creation framework, though, we first must understand the role of the public stock company.

PUBLIC STOCK COMPANIES AND SHAREHOLDER CAPITALISM

The public stock company is an important institutional arrangement in modern, free market economies. It provides goods and services as well as employment, pays taxes, and increases the standard of living. There exists an implicit contract based on trust between society and the public stock company. Society grants the right to incorporation, but in turn expects companies to be good citizens by adding value to society.

To fund future growth, companies frequently need to go public. Uber, featured in the ChapterCase, is one of the few companies that achieved a huge valuation before an initial public offering. Private start-up companies valued at a billion dollars or more are called unicorns, because at one time they seemed as rare as the mythical beast. But their elusiveness has changed. The tech sector now has the lion’s share: more than 160 unicorns valued at $1 billion or more, for a total of $615 billion. 6 The top five most valuable private startups (as of the summer of 2017) are Uber, Didi Chuxing (Chinese ride-hailingPage 422 company and mobile logistics network, similar to Uber), Xiaomi (Chinese smartphone maker), Airbnb, and Palantir. These new ventures may eventually go public such as did Snap (2017), Twitter (2013), Facebook (2012), and LinkedIn (2011). As long as these unicorns remain private, however, they do not have to follow the stringent financial reporting and auditing requirements that public stock companies do. Consider that there may be a connection between firm structure and the degree that it integrates ethics. Not needing to expose themselves to as much public scrutiny as a publicly traded company also allows unicorns such as Uber to push the envelope in their legal and ethical business practices. A potential downside is, however, that a track record of ethics and legal problems may prevent a successful initial public offering (IPO) in the future.

A picture of a unicorn. In capital markets, private companies that achieve a valuation of $1 billion or greater were once rare enough to be called unicorns. ©Catmando/Shutterstock.com RF

Exhibit 12.1 depicts the levels of hierarchy within a public stock company. The state or society grants a charter of incorporation to the company’s shareholders—its legal owners, who own stock in the company. The shareholders appoint a board of directors to govern and oversee the firm’s management. The managers hire, supervise, and coordinate employees to manufacture products and provide services. The public stock company enjoys four characteristics that make it an attractive corporate form: 7

EXHIBIT 12.1 The Public Stock Company: Hierarchy of Authority

A diagram. Access the text alternative for Exhibit 12.1

1. Limited liability for investors. This characteristic means the shareholders who provide the risk capital are liable only to the capital specifically invested, and not for other investments they may have made or for their personal wealth. Limited liability encourages investments by the wider public and entrepreneurial risk-taking.

2. Transferability of investor ownership through the trading of shares of stock on exchanges such as the New York Stock Exchange (NYSE) and NASDAQ, 8 or exchanges in other countries. Each share represents only a minute fraction of ownership in a company, thus easing transferability.

3. Legal personality—that is, the law regards a non-living entity such as a for-profit firm as similar to a person, with legal rights and obligations. Legal personality allows a firm’s continuation beyond the founder or the founder’s family.

4. Separation of legal ownership and management control. 9 In publicly traded companies, the stockholders (the principals, represented by the board of directors) are the legal owners of the company, and they delegate decision-making authority to professional managers (the agents).

The public stock company has been a major contributor to value creation since its inception as a new organizational form more than a hundred years ago. Michael Porter and others, however, argue that many public companies have defined value creation too narrowly in terms of financial performance. 10 This in turn has contributed to some of the black swan events discussed in Chapter 2 , such as large-scale accounting scandals and the global financial crisis. Managers’ pursuit of strategies that define value creation too narrowly may have negative consequences for society at large, as evidenced during the global financial crisis. This narrow focus has contributed to the loss of trust in the corporation as a vehicle for value creation, not only for shareholders but also other stakeholders and society.

Nobel laureate Milton Friedman stated his view of the firm’s social obligations: “There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.” 11 This notion is often captured by the term shareholder capitalism . According to this perspective, shareholders—the providers of the necessary risk capital and the legal owners of public companies—have the most legitimate claim on profits. When introducing the notion of corporate social responsibility (CSR) in Chapter 2 , though, we noted that a firm’s obligations frequently go beyond the economic responsibility to increase profits, extending to ethical and philanthropic expectations that society has of the business enterprise. 12

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A survey that measured attitudes toward business responsibility in various countries provides more insights into this debate and how opinions may vary across the globe. The survey asked the top 25 percent of income earners holding a university degree in each country surveyed whether they agree with Milton Friedman’s philosophy that “the social responsibility of business is to increase its profits.” 13 The results, displayed in Exhibit 12.2 , revealed intriguing national differences. The United Arab Emirates (UAE), a small and business-friendly federation of seven emirates, had the highest level of agreement, at 84 percent. Roughly two-thirds agreed in the Asian countries of Japan, India, South Korea, and Singapore, which completed the top five in the survey.

EXHIBIT 12.2 Global Survey of Attitudes toward Business Responsibility The bar chart indicates the percentage of members of the “informed public” who “strongly agree/somewhat agree” with Milton Friedman’s philosophy, “the social responsibility of business is to increase its profits.”

A bar chart.

Source: Depiction of data from Edelman’s, Trust Barometer, 2011 as included in “Milton Friedman goes on tour,” The Economist, January 27, 2011. Access the text alternative for Exhibit 12.2

The countries where the fewest people agreed with Friedman’s philosophy were China, Brazil, Germany, Italy, and Spain; fewer than 40 percent of respondents in those countries supported an exclusive focus on shareholder capitalism. Although they have achieved a high standard of living, European countries such as Germany have tempered the free market system with a strong social element, leading to so-called social market economies. The respondents from these countries seemed to be more supportive of a stakeholder strategy approach to business. Some critics, however, would argue that too strong a focus on the social dimension contributed to the European debt crisis because sovereign governments such as Greece, Italy, and Spain took on nonsustainable debt levels to fund social programs such as early retirement plans, government-funded health care, and so on. The United States placed roughly in the middle of the continuum—a bit more than half (56 percent) of U.S. respondents subscribed to Friedman’s philosophy.

CREATING SHARED VALUE

In contrast to Milton Friedman, Porter argues that executives should not concentrate exclusively on increasing firm profits. Rather, an effective strategic leader should focus on creating shared value, a concept that involves creating economic value for shareholders while also creating social value by addressing society’s needs and challenges. He argues that managers need to reestablish the important relationship between superior firm performance and societal progress. This dual point of view, Porter argues, will not only allowPage 424 companies to gain and sustain a competitive advantage but also reshape capitalism and its relationship to society.

The shared value creation framework proposes that managers maintain a dual focus on shareholder value creation and value creation for society. It recognizes that markets are defined not only by economic needs but also by societal needs. It also advances the perspective that externalities such as pollution, wasted energy, and costly accidents actually create internal costs, at least in lost reputation if not directly on the bottom line. Rather than pitting economic and societal needs in a trade-off, Porter suggests that the two can be reconciled to create a larger pie. The shared value creation framework seeks to enhance a firm’s competitiveness by identifying connections between economic and social needs, and then creating a competitive advantage by addressing these business opportunities.

GE, for example, has strengthened its competitiveness by creating a profitable business with its “green” Ecomagination initiative. Ecomagination is GE’s strategic initiative to provide cleaner and more efficient sources of energy, provide abundant sources of clean water anywhere in the world, and reduce emissions. 14 Jeffrey Immelt, GE’s former CEO, would often say, “Green is green,” 15 meaning that addressing ecological needs offers the potential of gaining and sustaining a competitive advantage for GE. Through applying strategic innovation, GE is providing solutions for some tough environmental challenges, while driving company growth at the same time. Ecomagination solutions and products allow GE to increase the perceived value it creates for its customers while lowering costs to produce and deliver the “green” products and services. Ecomagination allows GE to solve the trade-off between increasing value creation and lowering costs. This in turn enhances GE’s economic value creation and its competitive advantage.

Moreover, Ecomagination products and services also create value for society in terms of reducing emissions and lowering energy consumption, among other benefits. In 2016, “green” energy obtained from renewables (wind, solar, water, etc.) has for the first time surpassed coal in terms of electricity capacity additions. More than half of new energy capacity now comes from renewables and is estimated to be two-thirds within the next five years. In its sustainability report, GE says, “Investing in clean energy has proven good for business, job creation, the economy and the world.” Since launched in 2005, GE has invested $20 billion in Ecomagination and reported in 2017 that revenues from this strategic initiative alone have reached $270 billion to date. 16

To ensure that managers can reconnect economic and societal needs, Michael Porter recommends that managers focus on three things within the shared value creation framework: 17

1. Expand the customer base to bring in nonconsumers such as those at the bottom of the pyramid—the largest but poorest socioeconomic group of the world’s population. The bottom of the pyramid in the global economy can yield significant business opportunities, which—if satisfied—could improve the living standard of the world’s poorest. Muhammad Yunus, Nobel Peace Prize winner, founded Grameen Bank in Bangladesh to provide small loans (termed microcredit) to impoverished villagers, who used the funding for entrepreneurial ventures that would help them climb out of poverty. Other businesses have also found profitable opportunities at the bottom of the pyramid. In India, Arvind Ltd. offers jeans in a ready-to-make kit that costs only a fraction of the high-end Levi’s. The Tata group sells its Nano car for around 150,000 rupees (about $2,500), enabling more Indian families to move from mopeds to cars and potentially adding up to a substantial business.

2. Expand traditional internal firm value chains to include more nontraditional partners such as nongovernmental organizations (NGOs). NGOs are nonprofit organizations that pursue a particular cause in the public interest and are independent of any governments. Habitat for Humanity and Greenpeace are examples of NGOs.

3. Page 425Focus on creating new regional clusters such as Silicon Valley in the United States; Electronic City in Bangalore, India; and Chilecon Valley in Santiago, Chile.

In line with stakeholder theory (discussed in Chapter 2 ), Porter argues that these strategic actions will lead to a larger pie of revenues and profits that can be distributed among a company’s stakeholders. General Electric, for example, recognizes a convergence between shareholders and stakeholders to create shared value. It states in its governance principles: “Both the board of directors and management recognize that the long-term interests of shareowners are advanced by responsibly addressing the concerns of other stakeholders and interested parties, including employees, recruits, customers, suppliers, GE communities, government officials, and the public at large.” 18 To ensure that convergence takes place, companies need effective governance mechanisms, which we discuss next.

12.2 Corporate Governance
LO 12-2

Explain the role of corporate governance.

Corporate governance concerns the mechanisms to direct and control an enterprise in order to ensure that it pursues its strategic goals successfully and legally. 19 Corporate governance is about checks and balances and about asking the tough questions at the right time. The accounting scandals of the early 2000s and the global financial crisis of 2008 and beyond got so out of hand because the enterprises involved did not practice effective corporate governance. As discussed in the ChapterCase, some observers question whether Uber has effective corporate-governance mechanisms in place, or whether its ethically and legally questionable competitive tactics and decisions are part of a larger intended strategy to first dominate the mobile, on-demand logistics business and then to address any remaining stakeholder grievances.

Corporate governance attempts to address the principal–agent problem (introduced in Chapter 8 ), which can occur any time an agent performs activities on behalf of a principal. 20 This problem can arise whenever a principal delegates decision making and control over resources to agents, with the expectation that they will act in the principal’s best interest.

We mentioned earlier that the separation of ownership and control is one of the major advantages of the public stock companies. This benefit, however, is also the source of the principal–agent problem. In publicly traded companies, the stockholders are the legal owners of the company, but they delegate decision-making authority to professional managers. The conflict arises if the agents pursue their own personal interests, which can be at odds with the principals’ goals. For their part, agents may be more interested in maximizing their total compensation, including benefits, job security, status, and power. Principals desire maximization of total returns to shareholders.

The risk of opportunism on behalf of agents is exacerbated by information asymmetry: The agents are generally better informed than the principals. Exhibit 12.3 depicts the principal–agent relationship.

EXHIBIT 12.3 The Principal–Agent Problem

A graphic. Access the text alternative for Exhibit 12.3

Managers, executives, and board members tend to have access to private information concerning important company developments that outsiders, especially investors, arePage 426 not privy to. Often this informational advantage is based on timing—insiders are the first to learn about important developments before the information is released to the public. Although possessing insider information is not illegal and indeed is part of an executive’s job, what is illegal is acting upon it through trading stocks or passing on the information to others who might do so. Insider-trading cases, therefore, provide an example of egregious exploitation of information asymmetry. The hedge fund Galleon Group (holding assets worth $7 billion under management at its peak) was engulfed in an insider-trading scandal involving private information about important developments at companies such as Goldman Sachs, Google, IBM, Intel, and P&G. 21 Galleon Group’s founder, Raj Rajaratnam, the mastermind behind a complex network of informants, was sentenced to 11 years in prison and fined more than $150 million. In one instance, an Intel manager had provided Rajaratnam with internal Intel data such as orders for processors and production runs. These data indicated that demand for Intel processors was much higher than analysts had expected. Galleon bought Intel stock well before this information was public to benefit from the anticipated share appreciation.

In another instance, Rajaratnam benefited from insider tips provided by Rajat Gupta, a former McKinsey chief executive who served on Goldman Sachs’ board. Often within seconds after a Goldman Sachs board meeting ended, Gupta called Rajaratnam. In one of these phone calls, Gupta revealed the impending multibillion-dollar liquidity injection by Warren Buffett into Goldman Sachs during the midst of the global financial crisis. This information allowed the Galleon Group to buy Goldman Sachs shares before the official announcement about Buffett’s investment was made, profiting from the subsequent stock appreciation. In another call, Gupta informed Rajaratnam that the investment bank would miss earnings estimates. Based on this insider information, the Galleon Group was able to sell its holdings in Goldman Sachs stock before the announcement, avoiding a multimillion-dollar loss. 22

Information asymmetry also can breed on-the-job consumption, perquisites, and excessive compensation. Although use of company funds for golf outings, resort retreats, professional sporting events, or elegant dinners and other entertainment is an everyday manifestation of on-the-job consumption, other forms are more extreme. Dennis Kozlowski, former CEO of Tyco, a diversified conglomerate, used company funds for his $30 million New York City apartment (the shower curtain alone was $6,000) and for a $2 million birthday party for his second wife. 23 John Thain, former CEO of Merrill Lynch, spent $1.2 million of company funds on redecorating his office, while he demanded cost cutting and frugality from his employees. 24 Such uses of company funds, in effect, mean that shareholders pay for those items and activities. Thain also allegedly requested a bonus of up to $30 million in 2009 despite Merrill Lynch having lost billions of dollars and being unable to continue as an independent company. Merrill Lynch was later acquired by Bank of America in a fire sale.

LO 12-3

Apply agency theory to explain why and how companies use governance mechanisms to align interests of principals and agents.

AGENCY THEORY
The principal–agent problem is a core part of agency theory , which views the firm as a nexus of legal contracts. 25 In this perspective, corporations are viewed as a set of legal contracts between different parties. Conflicts that may arise are to be addressed in the legal realm. Agency theory finds its everyday application in employment contracts, for example.

Besides dealing with the relationship between shareholders and managers, principal–agent problems also cascade down the organizational hierarchy (shown in Exhibit 12.3 ). Senior executives, such as the CEO, face agency problems when they delegate authority of strategic business units to general managers.

One incident at Uber illustrates the principal–agent problem. Uber’s office in Lyon, France, ran a sexist ad campaign that promised rides with “avions de chasse” as drivers,Page 427 which is French for fighter jets, but colloquially it means “hot chicks.” The ads were accompanied by revealing photos of female models. Uber headquarters canceled the ad campaign and apologized for the “clear misjudgment by the local team.” Uber headquarters staff in the United States, therefore, claimed that the sexist ad campaign launched by its French office was based on an agency problem, explaining it as a “clear misjudgment by the local team.” The local team, however, thought this type of ad campaign would serve Uber well in France.

Employees who perform the actual operational labor are agents who work on behalf of the managers. Such frontline employees often enjoy an informational advantage over management. They may tell their supervisor that it took longer to complete a project or serve a customer than it actually did, for example. Some employees may be tempted to use such informational advantage for their own self-interest (e.g., spending time on Facebook during work hours, watching YouTube videos, or using the company’s computer and internet connection for personal business).

The lawsuit between Waymo and Uber (detailed in the ChapterCase) illustrates the thorny issues that arise out of the inherent principal–agent problem in employment relationships. 26 In this case, Anthony Levandowski, the engineer at the heart of the lawsuit between Waymo and Uber, is alleged to have set up his autonomous-vehicle company, Otto, while still working at Waymo as a front to siphon off trade secrets and proprietary technology from his employer. Shortly after Levandowski left Waymo formally, Uber acquired his start-up company for close to $700 million. Waymo alleges that Levandowski set up Otto to steal trade secrets and proprietary designs, and to turn around and use this knowledge to advance self-driving technology at Uber, which acquired Otto later in 2016. Waymo, therefore, alleges that Levandowski and Uber not only acted opportunistically but also illegally. This is a stark turnaround from the earlier close relationship between Alphabet and Uber. In particular, Google Ventures, Alphabet’s venture capital unit, had made a $200 million investment in the fledgling ride-hailing service in 2013. Alphabet’s chief legal counsel was also a board member at Uber. He resigned from Uber’s board one week after Uber acquired Otto.

The managerial implication of agency theory relates to the management functions of organization and control: The firm needs to design work tasks, incentives, and employment contracts and other control mechanisms in ways that minimize opportunism by agents. Such governance mechanisms are used to align incentives between principals and agents. These mechanisms need to be designed in such a fashion as to overcome two specific agency problems: adverse selection and moral hazard.

ADVERSE SELECTION
In general, adverse selection occurs when information asymmetry increases the likelihood of selecting inferior alternatives. In principal–agent relationships, for example, adverse selection describes a situation in which an agent misrepresents his or her ability to do the job. Such misrepresentation is common during the recruiting process. Once hired, the principal may not be able to accurately assess whether the agent can do the work for which he or she is being paid. The problem is especially pronounced in team production, when the principal often cannot ascertain the contributions of individual team members. This creates an incentive for opportunistic employees to free-ride on the efforts of others.

MORAL HAZARD
In general, moral hazard describes a situation in which information asymmetry increases the incentive of one party to take undue risks or shirk other responsibilities because the costs accrue to the other party. For example, bailing out homeowners from their mortgage obligations or bailing out banks from the consequences of undue risk-taking in lending are examples of moral hazard. The costs of default are rolled over to society. Knowing that there is a high probability of being bailed out (“too big to fail”) increases moral hazard. In this scenario, any profits remain private, while losses become public.

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In the principal–agent relationship, moral hazard describes the difficulty of the principal to ascertain whether the agent has really put forth a best effort. In this situation, the agent is able to do the work but may decide not to do so. For example, a company scientist at a biotechnology company may decide to work on his own research project, hoping to eventually start his own firm, rather than on the project he was assigned. 27 While working on his own research on company time, she might also use the company’s laboratory and technicians. Given the complexities of basic research, it is often challenging, especially for nonscientist principals, to ascertain which problem a scientist is working on. 28 To overcome these principal–agent problems, firms put several governance mechanisms in place. We shall discuss several of them next, beginning with the board of directors.

THE BOARD OF DIRECTORS
LO 12-4

Evaluate the board of directors as the central governance mechanism for public stock companies.

The shareholders of public stock companies appoint a board of directors to represent their interests (see Exhibit 12.1 ). The board of directors is the centerpiece of corporate governance in such companies. The shareholders’ interests, however, are not uniform. The goals of some shareholders, such as institutional investors (e.g., retirement funds, governmental bodies, and so on), are generally the long-term viability of the enterprise combined with profitable growth. Long-term viability and profitable growth should allow consistent dividend payments and result in stock appreciation over time. The goals of other shareholders, such as hedge funds, are often to profit from short-term movements of stock prices. These more proactive investors often demand changes in a firm’s strategy, such as spinning out certain divisions or splitting up companies into parts to enhance overall performance. Votes at shareholder meetings, generally in proportion to the amount of ownership, determine whose representatives are appointed to the board of directors.

The day-to-day business operations of a publicly traded stock company are conducted by its managers and employees, under the direction of the chief executive officer (CEO) and the oversight of the board of directors. The board of directors is composed of inside and outside directors who are elected by the shareholders: 29

· ▪ Inside directors are generally part of the company’s senior management team, such as the chief financial officer (CFO) and the chief operating officer (COO). They are appointed by shareholders to provide the board with necessary information pertaining to the company’s internal workings and performance. Without this valuable inside information, the board would not be able to effectively monitor the firm. As senior executives, however, inside board members’ interests tend to align with management and the CEO rather than the shareholders.

· ▪ Outside directors , on the other hand, are not employees of the firm. They frequently are senior executives from other firms or full-time professionals, who are appointed to a board and who serve on several boards simultaneously. Given their independence, they are more likely to watch out for the interests of shareholders.

The board is elected by the shareholders to represent their interests. Each director has a fiduciary responsibility—a legal duty to act solely in another party’s interests—toward the shareholders because of the trust placed in him or her. Prior to the annual shareholders’ meeting, the board proposes a slate of nominees, although shareholders can also directly nominate director candidates. In general, large institutional investors support their favored candidates through their accumulated proxy votes. The board members meet several times a year to review and evaluate the company’s performance and to assess its future strategic plans as well as opportunities and threats. In addition to general strategic oversight and guidance, the board of directors has other, more specific functions, including:

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· ▪ Selecting, evaluating, and compensating the CEO. The CEO reports to the board. Should the CEO lose the board’s confidence, the board may fire him or her.

· ▪ Overseeing the company’s CEO succession plan.

· ▪ Providing guidance to the CEO in the selection, evaluation, and compensation of other senior executives.

· ▪ Reviewing, monitoring, evaluating, and approving any significant strategic initiatives and corporate actions such as large acquisitions.

· ▪ Conducting a thorough risk assessment and proposing options to mitigate risk. The boards of directors of the financial firms at the center of the global financial crisis were faulted for not noticing or not appreciating the risks the firms were exposed to.

· ▪ Ensuring that the firm’s audited financial statements represent a true and accurate picture of the firm.

· ▪ Ensuring the firm’s compliance with laws and regulations. The boards of directors of firms caught up in the large accounting scandals were faulted for being negligent in their company oversight and not adequately performing several of the functions listed here.

Board independence is critical to effectively fulfilling a board’s governance responsibilities. Given that board members are directly responsible to shareholders, they have an incentive to ensure that the shareholders’ interests are pursued. If not, they can experience a loss in reputation or can be removed outright. More and more directors are also exposed to legal repercussions should they fail in their fiduciary responsibility. To perform their strategic oversight tasks, board members apply the strategic management theories and concepts presented herein, among other more specialized tools such as those originating in finance and accounting.

To make the workings of a board of directors more concrete, Strategy Highlight 12.1 takes a close look at corporate governance at General Electric.

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Strategy Highlight 12.1
GE’s Board of Directors
GE describes the role of its board of directors as follows:

“The primary role of GE’s Board of Directors is to oversee how management serves the interests of shareowners and other stakeholders. To do this, GE’s directors have adopted corporate governance principles aimed at ensuring that the Board is independent and fully informed on the key strategic and risk issues GE faces.… Each independent director is expected to visit at least two GE businesses without the involvement of corporate management.” 30

The GE board is composed of individuals from the business world (chairpersons and CEOs of Fortune 500 companies spanning a range of industries), academia (business school and science professors, deans, and provosts), and government (SEC). Including the board’s chairperson, GE’s board has 18 members. Experts in corporate governance consider that an appropriate number of directors for a company of GE’s size (roughly $120 billion in annual revenues, which makes GE the largest industrial enterprise globally).

As of 2017, 17 of the 18 board members (94 percent) are independent outside directors. To achieve board independence, experts in corporate governance recommend that two-thirds of its directors be outsiders. GE’s board tries to maintain only one inside director. This was demonstrated when former CEO Jeffrey Immelt retired in 2017. John Flannery took over in August, with Immelt scheduled to remain chairman of the board through the end of the year, after which Flannery would take over. In roughly half of U.S. public firms, the CEO of the company also serves as chair of the board of directors. 31

GE’s board of directors meets a dozen or more times annually. With increasing board accountability in recent years, boards now tend to meet more often. Many firms limit the number and type of directorships a board member may hold concurrently. To accomplish their responsibilities, boards of directors are usually organized into committees. GE’s board has four committees, each with its own chair: the audit committee, the management development and compensation committee, the government and public affairs committee, and the technology and industrial risk committee.

In general, women and minorities remain underrepresented on boards of directors across the United States and throughout most of the world. GE’s board is somewhat more diverse in gender when compared with other Fortune 500 companies, which in 2016 averaged roughly 20 percent women on their boards versus 28 percent for GE. 32

Generally, the larger the company, the greater its gender diversity, as demonstrated in recent years by tracking different levels of the Fortune 1000. For example, in 2016 boards of the Fortune 100 companies averaged 22 percent gender diversity; of the Fortune 500 (as noted), 20 percent; and of the bottom half of the Fortune 1000, 16 percent. GE as of this writing ranks number eight in the Fortune 1000 rankings in terms of gender diversity. 33

Diversity in backgrounds and expertise in the boardroom is considered an asset: More diverse boards are less likely to fall victim to groupthink, a situation in which opinions coalesce around a leader without individuals critically challenging and evaluating that leader’s opinions and assumptions. 34

As discussed in Strategy Highlight 12.1 , at GE the CEO normally serves not only as the chief executive officer of the roughly $240 billion conglomerate in market cap, but also as chairman of the board. This practice of CEO/chairperson duality —holding both the role of CEO and chairperson of the board—has been declining somewhat in recent years. 35 Among the largest 500 publicly traded companies in the United States, almost 70 percent of firms had the dual CEO-chair arrangement in 2005 (before the global financial crisis), but this number had declined to 52 percent of companies in 2016 (post global financial crisis).

The functions of the CEO and chairperson of the board roles are distinctly different. A board of directors broadly oversees a company’s business activities. The company’s CEO reports to the board of directors and acts as a liaison between the company and the board. The CEO has high-level responsibilities of strategy and all other management activities of a company while the functions of the board of directors include approving the annual budget and dealing with stakeholders. Moreover, a CEO is the public face of a company or organization and takes the hit or pat on the back if a company fails or succeeds, while the board of directors is there to steer a company on behalf of shareholders.

Arguments can be made both for and against splitting the roles of CEO and chairperson of the board. On the one hand, the CEO has invaluable inside information that can help in chairing the board effectively. The benefit of a combined CEO and chair of the board is the unity streamlines and speeds the decision-making process as well as strategy implementation. On the other hand, the chairperson may influence the board unduly through setting the meeting agendas or suggesting board appointees who are friendly toward the CEO. Because one of the key roles of the board is to monitor and evaluate the CEO’s performance, there can be a conflict of interest when the CEO actually chairs the board.

OTHER GOVERNANCE MECHANISMS
LO 12-5

Evaluate other governance mechanisms.

While the board of directors is the central governance piece for a public stock company, several other corporate mechanisms are also used to align incentives between principals and agents, including

· ▪ Executive compensation.

· ▪ The market for corporate control.

· ▪ Financial statement auditors, government regulators, and industry analysts.

EXECUTIVE COMPENSATION
The board of directors determines executive compensation packages. To align incentives between shareholders and management, the board frequentlyPage 431 grants stock options as part of the compensation package. This mechanism is based on agency theory and gives the recipient the right, but not the obligation, to buy a company’s stock at a predetermined price sometime in the future. If the company’s share price rises above the negotiated strike price, which is often the price on the day when compensation is negotiated, the executive stands to reap significant gains.

The topic of executive compensation—and CEO pay, in particular—has attracted significant attention in recent years. Two issues are at the forefront:

1. The absolute size of the CEO pay package compared with the pay of the average employee.

2. The relationship between CEO pay and firm performance.

Absolute Size of Pay Package.

The ratio of CEO to average employee pay in the United States is about 300 to 1, up from roughly 40 to 1 in 1980. 36 Based on a 2017 survey of CEOs in the S&P 500 by The Wall Street Journal, the median annual compensation was about $11 million. 37 Note: Annual compensation is broadly defined to include salary, stock options, equity grants, bonuses, and pension payments.

The five highest paid CEOs were Thomas Rutledge of Charter Communications ($98.5 million), Fabrizio Freda of Estée Lauder ($48.4 million), Mark Parker of Nike ($47.6 million), Alex Molinaroli of Johnson Controls ($46.4 million), and Robert Iger of Disney ($43.9 million). Noteworthy are also the two lowest paid CEOs in the S&P 500: Warren Buffett of Berkshire Hathaway ($470,000) and Larry Page of Alphabet ($1, the minimum payment required). 38

CEO Pay and Firm Performance.

Overall, survey results also show that two-thirds of CEO pay is linked to firm performance. 39 The relationship between pay and performance is positive, but the link is weak at best. Although agency theory would predict a positive link between pay and performance as this aligns incentives, some recent experiments in behavioral economics caution that incentives that are too high-powered (e.g., outsized bonuses) may have a negative effect on job performance. 40 That is, when the incentive level is very high, an individual may get distracted from strategic activities because too much attention is devoted to the outsized bonus to be enjoyed in the near future. This can further increase job stress and negatively impact job performance.

THE MARKET FOR CORPORATE CONTROL
Whereas the board of directors and executive compensation are internal corporate-governance mechanisms, the market for corporate control is an important external corporate-governance mechanism. It consists of activist investors who seek to gain control of an underperforming corporation by buying shares of its stock in the open market. To avoid such attempts, corporate managers strive to protect shareholder value by delivering strong share-price performance or putting in place poison pills (discussed later).

Here’s how the market for corporate control works: If a company is poorly managed, its performance suffers and its stock price falls as more and more investors sell their shares. Once shares fall to a low enough level, the firm may become the target of a hostile takeover (as discussed in Chapter 9 ) when new bidders believe they can fix the internal problems that are causing the performance decline. Besides competitors, so-called corporate raiders (e.g., Carl Icahn and T. Boone Pickens) or private equity firms and hedge funds (e.g., The Blackstone Group and Pershing Square Capital Management) may buy enough shares to exert control over a company.

In a leveraged buyout (LBO) , a single investor or group of investors buys, with the help of borrowed money (leveraged against the company’s assets), the outstanding sharesPage 432 of a publicly traded company in order to take it private. In short, an LBO changes the ownership structure of a company from public to private. The expectation is often that the private owners will restructure the company and eventually take it public again through an initial public offering (IPO).

Private companies enjoy certain benefits that public companies do not. Private companies are not required to disclose financial statements. They experience less scrutiny from analysts and can often focus more on long-term viability. These are also some of the reasons some unicorns delay going public in the first place.

In 2013, computer maker Dell Inc. became a takeover target of famed corporate raider Carl Icahn. 41 He jumped into action after Dell’s founder and its largest shareholder, Michael Dell, announced in January of that year that he intended a leveraged buyout with the help of Silverlake Partners, a private equity firm, to take the company private. In the Dell buyout battle, many observers, including Icahn who is the second-largest shareholder of Dell, saw the attempt by Michael Dell to take the company private as the “ultimate insider trade.”

This view implied that Michael Dell, who is also CEO and chairman, had private information about the future value of the company and that his offer was too low. Dell Inc., which had $57 billion in revenues in its fiscal year 2013, has been struggling in the ongoing transition from personal computers such as desktops and laptops to mobile devices and services. Between December 2004 and February 2009, Dell (which until just a few years earlier was the number-one computer maker) lost more than 80 percent of its market capitalization, dropping from some $76 billion to a mere $14 billion. In late 2013, Dell’s shareholders approved the founder’s $25 billion offer to take the company private, thus avoiding a hostile takeover.

If a hostile takeover attempt is successful, however, the new owner frequently replaces the old management and board of directors to manage the company in a way that creates more value for shareholders. In some instances, the new owner will break up the company and sell its pieces. In either case, since a firm’s existing executives face the threat of losing their jobs and their reputations if the firm sustains a competitive disadvantage, the market for corporate control is a credible governance mechanism.

To avoid being taken over against their consent, some firms put in place a poison pill . These are defensive provisions that kick in should a buyer reach a certain level of share ownership without top management approval. For example, a poison pill could allow existing shareholders to buy additional shares at a steep discount. Those additional shares would make any takeover attempt much more expensive and function as a deterrent. With the rise of actively involved institutional investors, poison pills have become rare because they retard an effective function of equity markets.

Although poison pills are becoming rarer, the market for corporate control is alive and well, as shown in the battle over control of Dell Inc. or the hostile takeover of Cadbury by Kraft (featured in Strategy Highlight 9.2 ). However, the market for corporate control is a last resort because it comes with significant transaction costs. To succeed in its hostile takeover bid, buyers generally pay a significant premium over the given share price. This often leads to overpaying for the acquisition and subsequent shareholder value destruction—the so-called winner’s curse. The market for corporate control is useful, however, when internal corporate-governance mechanisms have not functioned effectively and the company is underperforming.

AUDITORS, GOVERNMENT REGULATORS, AND INDUSTRY ANALYSTS
Auditors, government regulators, and industry analysts serve as additional external-governance mechanisms. All public companies listed on the U.S. stock exchanges must file a number ofPage 433 financial statements with the Securities and Exchange Commission (SEC), a federal regulatory agency whose task it is to oversee stock trading and enforce federal securities laws. To avoid the misrepresentation of financial results, all public financial statements must follow generally accepted accounting principles (GAAP) 42 and be audited by certified public accountants.

As part of its disclosure policy, the SEC makes all financial reports filed by public companies available electronically via the EDGAR database. 43 This database contains more than 7 million financial statements, going back several years. Industry analysts scrutinize these reports in great detail, trying to identify any financial irregularities and assess firm performance. Given recent high-profile oversights in accounting scandals and fraud cases, the SEC has come under pressure to step up its monitoring and enforcement.

Industry analysts often base their buy, hold, or sell recommendations on financial statements filed with the SEC and business news published in The Wall Street Journal, Bloomberg Businessweek, Fortune, Forbes, and other business media such as CNBC. Researchers have questioned the independence of industry analysts and credit-rating agencies that evaluate companies (such as Fitch Ratings, Moody’s, and Standard & Poor’s), 44 because the investment banks and rating agencies frequently have lucrative business relationships with the companies they are supposed to evaluate, creating conflicts of interest. A study of over 8,000 analysts’ ratings of corporate equity securities, for example, revealed that investment bankers rated their own clients more favorably. 45

In addition, an industry has sprung up around assessing the effectiveness of corporate governance in individual firms. Research outfits, such as GMI Ratings, 46 provide independent corporate governance ratings. The ratings from these external watchdog organizations inform a wide range of stakeholders, including investors, insurers, auditors, regulators, and others.

Corporate-governance mechanisms play an important part in aligning the interests of principals and agents. They enable closer monitoring and controlling, as well as provide incentives to align interests of principals and agents. Perhaps even more important are the “most internal of control mechanisms”: business ethics—a topic we discuss next.

12.3 Strategy and Business Ethics
LO 12-6

Explain the relationship between strategy and business ethics.

Multiple, high-profile accounting scandals and the global financial crisis have placed business ethics center stage in the public eye. Business ethics are an agreed-upon code of conduct in business, based on societal norms. Business ethics lay the foundation and provide training for “behavior that is consistent with the principles, norms, and standards of business practice that have been agreed upon by society.” 47 These principles, norms, and standards of business practice differ to some degree in different cultures around the globe. But a large number of research studies have found that some notions—such as fairness, honesty, and reciprocity—are universal norms. 48 As such, many of these values have been codified into law.

Law and ethics, however, are not synonymous. This distinction is important and not always understood by the general public. Staying within the law is a minimum acceptable standard. A note of caution is therefore in order: A manager’s actions can be completely legal, but ethically questionable. For example, consider the actions of mortgage-loan officers who—being incentivized by commissions—persuaded unsuspecting consumers to sign up for exotic mortgages, such as “option ARMs.” These mortgages offer borrowers the choice to pay less than the required interest, which is then added to the principal while the interest rate can adjust upward. Such actions may be legal, but they are unethical, especially if there are indications that the borrower might be unable to repay the mortgage once the interest rate moves up. 49

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To go beyond the minimum acceptable standard codified in law, many organizations have explicit codes of conduct. These codes go above and beyond the law in detailing how the organization expects an employee to behave and to represent the company in business dealings. Codes of conduct allow an organization to overcome moral hazards and adverse selections as they attempt to resonate with employees’ deeper values of justice, fairness, honesty, integrity, and reciprocity. Since business decisions are not made in a vacuum but are embedded within a societal context that expects ethical behavior, managers can improve their decision making by also considering:

· ▪ When facing an ethical dilemma, a manager can ask whether the intended course of action falls within the acceptable norms of professional behavior as outlined in the organization’s code of conduct and defined by the profession at large.

· ▪ The manager should imagine whether he or she would feel comfortable explaining and defending the decision in public. How would the media report the business decision if it were to become public? How would the company’s stakeholders feel about it?

Strategy Highlight 12.2 features Goldman Sachs, which came under scrutiny and faced tough questions pertaining to its business dealings in the wake of the financial crisis of 2007–2008.

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Strategy Highlight 12.2
Why the Mild Response to Goldman Sachs and Securities Fraud?
Long after the SEC sued Goldman Sachs and one of its employees, Fabrice Tourre, for securities fraud, social critics continue to question what is now seen as a mild response by both the SEC and the Justice Department. (The SEC oversees civil enforcement of U.S. securities law; the Justice Department pursues criminal cases, often based on SEC investigations. Both can target institutions and individuals.)

The SEC’s case in April 2010 was narrow, looking at a specific, mortgage-related scheme hatched in 2006 during the height of a U.S. real estate bubble. Then many investors assumed house prices could only go up, after years of consistent real estate appreciation. Indeed, real estate prices in the United States had continued to surge, as speculation was added to organic demand. The frenzy was also fueled by cheap mortgages, many of them extended to home buyers who really couldn’t afford them. John Paulson, founder of the hedge fund Paulson & Co., saw the looming collapse—and a way to profit. He approached Goldman Sachs with a trading idea betting that the bubble would soon burst.

HIDDEN POISON. Paulson asked Goldman Sachs to create an investment instrument, later named “Abacus,” designed specifically to maximize returns on his bet. Goldman Sachs agreed and assigned Tourre to put it together. Tourre bundled thousands of mortgages into bonds, which theoretically would provide stable and regular interest payments (but only as long as the borrowers made mortgage payments). Such a bundle is known as a collateralized debt obligation (CDO). CDOs are considered safer investment choices than owning individual loans themselves; risks of losses through default are evened out across a broad number of loans; the bigger the bundle, theoretically, the more stable the investment. But with Abacus, Paulson was helping Goldman Sachs by identifying the riskiest of CDOs to include in the bundle.

Rating agencies, including Standard & Poor’s, Fitch, and Moody’s, frequently rated CDOs as triple A. This is the highest possible rating and indicates an “extremely strong capacity” for the borrower to meet its financial obligation. Only a few companies, such as Exxon, Johnson & Johnson, and Microsoft, hold a triple A rating. Rating agencies may have been lulled by the traditional stability of CDO offerings and the general euphoria around real estate. They rubber-stamped Abacus as a triple A investment, and many institutional investors, such as pension funds, snapped it up. The investment seemed above reproach: Triple A Abacus was offered by Goldman Sachs, the number-one investment bank in the world.