Corporate Strategy

Professor Deepak Somaya

Module 4: Stakeholders and Governance

Table of Contents
Lesson 1-1: Stakeholders and Governance.......................................................................................2
Lesson 1-1.1 Public Firms and Their Role in Society ............................................................................................. 2
Lesson 1-1.2: Corporate Social Responsibility....................................................................................................... 9
Lesson 1-1.3 Mechanisms of Corporate Governance ......................................................................................... 16
Lesson 1-1.4 Recent Developments .................................................................................................................... 23

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Professor Deepak Somaya

Lesson 1-1: Stakeholders and Governance

Lesson 1-1.1 Public Firms and Their Role in Society

Hello and welcome to this module on Stakeholders and Corporate Governance. This is
a topic that's of great significance in today's sociopolitical environment, where
fundamental questions are being asked about how companies and their managers
behave, and the role that companies should play in economics, politics, and society at
large. In this module, we begin with a brief introduction to the topic and then focus on
three core areas: the public firm, corporate social responsibility, and the various
mechanisms of governance that one sees in modern corporations. The lectures on
these core areas will be led by Professor Joe Mahoney, who has great expertise on
these topics. I will then return to provide an outline of interesting current developments
and conclude the module.

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I want to begin by noting that companies have always operated within a nexus of
different stakeholders. These include external stakeholders such as customers and
suppliers, the government and community. But they also include internal stakeholders
such as shareholders and bondholders, employees and board managers. The success
of companies has always depended on how they manage the interests of these different
shareholders and balance them against each other.

However, over the last few decades, managers and companies have increasingly

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operated in what one might call an age of shareholder primacy. During this period, and
especially in developed western, and particularly, English-speaking economies, the
interest of one set of stakeholders, the shareholders, has gotten elevated above all else
and often to the detriment of other stakeholders. So for example, in both management,
education, and practice, we often use the shorthand that the goal of managers is to
maximize returns for shareholders. Now, under certain conditions, the problem of
management can be reduced to the shorthand. But a quick thought experiment will
reveal to you that this might not be universally true. If, as a company, I could pollute the
groundwater around my facility without being detected for many years, and even pay off
local governments to turn a blind eye, should I do it? Very likely it will actually increase
shareholder returns, but I hope you see that this would not be good management
practice. Why then have shareholders and shareholder returns become a driving force
in modern management? For one thing, it reflects the reality that public corporations
take money from equity investors who are the claimants of last resort, the residual
claimants of value created by the company, and so perhaps their interests need
extraordinary protection. But it is also true that the shareholder-centric worldview has
been driven by an intellectual movement in economics and finance that emphasizes a
market-centric neoliberal worldview. Last but not least, it has been strongly reinforced
by the fact that modern financial markets are a very powerful force. Any CEO who's not
careful about shareholder returns is liable to get immediately punished in the stock
market and to receive pressure from the company's board. So with that background, let
me hand you over to the capable hands of Professor Mahoney, who will explain the
core topics of the publicly-traded corporation, corporate social responsibility, and
mechanisms of governance.

In particular, we'll look at the publicly traded corporation, or sometimes referred to as a

public stock company, which is the backbone of our economy. What are the
characteristics of a public firm? Well, four key ones are first, that there's limited liability

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for investors. Many people would define that as a key to a publicly traded corporation.
The second, the technical term is transferability of investor interest, but what that
essentially means is that the owners of stock can buy and sell stock. The third one is
called legal personality, and it's sometimes in the news. There's a lot of discussion of
the idea of the corporation as a person. The legal advantage of this idea of a single
entity of a person is that the Board of Directors, then, it is responsible for that person to
use that analogy or metaphor. That is, the Board of Directors is responsible for all of the
stakeholders in the corporation, what's in the best interest of the corporation itself.
Finally, the last aspect that's a fact about most publicly traded companies is that there's
a separation of ownership and control. In particular, if we think of ownership, it's who
gets the extra income beyond paying off all the other stakeholders with that residual
income or the residual claim in this call to shareholder. So in terms of income, the
ownership is with the stockholders. But there's another meaning of ownership, and that
is who has control? Typically, the managers have control. Now that means with a
separation of ownership and control, there's the question of will the managers act in the
best interest of the shareholders? Sometimes at the Harvard Business School, they call
that OPM or other people's money. There's actually a movie of that title also, that's
connected to these problems of separation of ownership and control. It has Danny
Devito in it, as I recall.

The next is this a picture of within many textbooks about the hierarchical nature of a
publicly traded company. So at the top you have the rules of the game of the state.
Different states have different rules of the game and some are more well-defined than
others. So the State of Delaware, for example, is one of the oldest states in the United
States, has many incorporated entities within that state. So they have the most well-
defined property rights of all the States to the United States. Therefore, a lot of
companies like to incorporate in the State of Delaware because they have less
ambiguity about the rules of the game when they incorporate in Delaware. Once you get

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beyond the state's rules of the game, you also have the rules of the game of the
corporation itself in the corporate charter of the company. There it is, a pecking order. In
most textbooks, it's as it is on the screen. Here, it's the shareholders who then vote for
the board of directors. The board of directors have the responsibility for the
management and the management has responsibility for the employees. I will point out
a nuance point though, is that you may have noticed a moment ago, I said, the board of
directors is in charge of the legal personality of the corporation itself which includes all
stakeholders. So in some pictures, we actually would switch. If you have a stakeholder
view of management which I do. This is a stockholder view of management. If you have
a stakeholder view, you would actually put the pecking order a little bit differently. You'd
put the board of directors actually above the shareholders. That is, the board of
directors is not only responsible for the shareholders. The board of directors is
responsible to all stakeholders of the company. That's the meaning of the legal
personality. That's the fiduciary duty of the board of directors. Next, we have the
discussion of, there's many problems in all types of organization, including our focus on
capitalists organizations. The final point I'll make about this slide on the public stock
company is the state charter of all 50 states in the United States are different and have
different corporate governance rules. As we talk about different countries like Germany,
France, China, Japan, they each also have their own corporate laws within each of
those countries. So in the same way that we have variation within a country like the
United States here, later on, we'll also talk about variation in corporate governance
across countries as well.

Some of them have to do with the separation of ownership and control and agency
problems. So managers acting in their own self-interest and some get very high profile
like Enron Corporation, WorldCom, and Tyco. Enron did all type of things. Their
accounting, for example. The simplistic version of what they were doing is, suppose you
buy someone's house and you have someone buy your house and then you put it down

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as revenue for both of you, and then you barter your houses back. So essentially, they
don't do anything, but the books make it look like they're collecting lots of revenue and
trying to move up their stock price and get more bonuses and things like that. The
second is, of course, the global financial crisis and the real estate bubble burst. That
also was, real estate folks got a lot of money when they made these deals. Often they
would make deals with people that they really had no ability to pay back. As you have
more and more houses like that on the market, eventually there was a collapse in the
pricing. That's what occurred in the United States for the real estate bubble. What these
examples then show is that managerial actions affect the economy. For example, the
Enron one, they also were in California, they deliberately manipulated the energy and
deliberately had shortages, and then you had blackouts in the State of California, you
had the rescinding of the Governor in California, and in his place came Arnold
Schwarzenegger onto the scene. I mean all that came about largely because of the
actions of Enron and their manipulations in the State of California. So these ethical
business procedures when they're in place, have positive impacts, so when they're not
in place, they can have very negative impacts and destroy value in the economy. So the
bottom line is that stakeholder management is quite important and needed.

So your question for discussion is, consider the case of a pharmaceutical company that
discovers a drug that can cure a disease that's prevalent in Africa. Suppose this drug is
projected to provide very low economic returns if the pharmaceutical company
distributes the drug in Africa. But this is a real question for many pharmaceutical
companies, should the pharmaceutical company go ahead with the distribution of the
drug, and on what basis do you defend your decision? Please reflect on this question
and post your response in the discussions for this video. Thank you.

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We've been discussing the idea of stakeholder analysis, and here would be the step-by-
step procedures or routines for doing a stakeholder impact analysis. The first question is
to ask who are the stakeholders? We might consider the employees, the customers, the
suppliers, the community. So whoever can be affected or affect the corporation are
typically included as stakeholders. The next thing is, what are the stakeholders' interests
and claims? You just had a discussion about the pharmaceutical industries and the
giving away of drugs. So for example, those patients in Africa are definitely going to be
for giving away the drug. Perhaps the shareholders might be against giving away the
drug, the employees might be varied if they're the scientists in the company, they don't
know the meaning of NPV or not that interested in the shareholder wealth unless their
company has a lot of scientists, have stock options, which is not always the case. So
they may be much more focused on scientific problems, and they are in the company to
have an impact positively on the world in terms of the drugs they are providing. So they
might actually be for the distribution of the drug. Then as a manager, you have to think
about you got pressures from the shareholders saying, "Don't do it," you got pressures
from your employees saying, "Do it." If the scientist are the key employees of the
company and they're going to walk if you don't do it, then the shareholder wealth can be
affected there as well because they have a lot of the value of the companies and the
employees. So managers in many companies, whether they want to or not, cannot
simply have a simplified version of just maximize the share price because that's actually
very much intertwined with the decisions of the stakeholders. So the next step in the
process, then is what are all the opportunities and threats do all these stakeholders
present, and that lead to a systematic analysis of all the stakeholder groups and what
are their interests? Really what you're trying to get is a decision that keeps the coalition
together, that you don't have the employees walk, you don't have the shareholders in
mass, sell off the stock. So a manager, you can think of just trying to balance, and some
ways in a positive sense of the word politician, we don't use that term always in a

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positive way, but in a positive sense of a politician of the policy of keeping the
organization together and making sure that might affect the most important stakeholder
you don't want exiting or your customers. The next step then is to think about what
economic, legal, ethical, and philanthropic responsibilities do we have as the
stakeholder? So those are all different levels of analysis. In our next video, we'll actually
discuss what's called the corporate social responsibility pyramid. Finally, the last step is,
what should we do to effectively address the stakeholder concerns? So the stakeholder
impact analysis is really looking at what impacts corporate performance, and it's looking
at issues of corporate governance, which we'll get to in more detail in the next two
videos, it also looks at business ethics, and then it also looks at issues of social
responsibility. So that's it for this time, and I look forward to seeing you for the next
video. Thank you.

Lesson 1-1.2: Corporate Social Responsibility

Okay. For this video, we'll start with discussing The Pyramid of Corporate Social
Responsibility. Throughout this course, we've talked about gaining and sustaining
competitive advantage, and that's the responsibility of the managers. But the manager's
responsibilities are much more than just the economic responsibilities. Clearly, they also
have legal responsibilities. They have laws and regulations in place and they have to
make sure that they stay within the guidelines of those rules and that also for the
protection of the economic interest of the company as well. Beyond that, there's also the
ethical responsibilities of doing what is right, just and fair. There's a very famous
categorization scheme of knowledge by a person named Bloom, and Bloom had this
taxonomy of knowledge. At the first level, is the level of description that's, do you
understand the material and can you show that you have competence in the material?

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In many ways, what we're doing in learning this material is that fundamental level of
knowledge. Going beyond that, you can also keep taking it up to the next level of
analysis, can you take knowledge and take it apart and look at its individual parts? The
next level is, can you take that and put a synthesis and put it back together? As an
example, I would say when I was about 10 years old, I got very fascinated with my
parent's phone. So I was very analytical and I took the phone all apart. But I found out at
the time I was 10, I wasn't very good at synthesis because I couldn't put it back together
the way it was and I originally started. Now beyond that, the next level is application.
Can you take the knowledge that you had and apply it to a new situation? So that really
shows a deep understanding. What made me think of Bloom's Taxonomy is actually
ethical responsibilities is what Bloom would call the highest level in his taxonomy, and
that is when a student starts to not ask the question, am I doing this right? They start to
ask the question, am I doing the right thing? Then that's what Bloom regards as a very
high level of education at that point when you start habitually think that way. At the
highest level, it's even beyond doing the right thing within the organization itself, is there
are question of, are you doing the right thing for others beyond the corporation? Or is
the organization a corporate citizen not only to the corporation itself, but is it a corporate
citizen to the world beyond the boundaries of that corporation?

Your question then goes to a comment by Milton Friedman, a famous economist, Nobel
Prize-winning economist from University of Chicago, who stated that "the only social
responsibility of business is to increase profits so long as it stays within the rules of the
game." So the question is, are philanthropic responsibilities part of the public
corporations responsibility, or is its only social responsibility to increase profits? Please

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reflect on this question and post your response in the discussions for this video. Thank
you.

So Milton Friedman circa 1962, noted as, ''The only social responsibility of business is
to increase profits.'' This is probably often is left out of the quote. ''So long as it stays
within the rules of the game.'' So he does have an ethical aspect to it, but not good. But
just staying within the legal boundaries and making profits. So in some sense in our
pyramid, it's really mostly the first two levels; the economic responsibility, the legal
responsibility. So the issue then is for today's businesses, it tends to be more than just
making profits. So the question is, does corporate social responsibility or CSR, help
build competitive advantage? Then the answer also might depend on where you do
business. So for example, United Arab Emirates, Japan, and India are less interested in
corporate social responsibility. While other countries like China, Brazil, and especially
Germany are more interested in CSR.

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Here's an example here of a survey done, recent survey done, and ask the question
about whether you agree or not that the social responsibility of business is to increase
profits, which is at least somewhat agree that there's social responsibility of business.
So United Arab Emirates is at one extreme focusing mostly on profits. But you have
other companies to the right of the US such as China, Brazil, Germany, Italy, and Spain,
with Spain being the most social responsibility oriented managers on average, and
United Arab Emirates being at the other extreme in the variance in this figure.

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So corporate social responsibility then can also be considered in terms of a value
creation framework, and that framework would consider the following. What's your
customer base and how are you bringing in non-consumers, expanding the internal
firm's value chains by including more non-traditional partners and focusing on creating
new regional clusters? In other words, generating a larger base for the reach of that or
sometimes called the footprint of the organization. So some companies actually try to
reconcile the shareholder and stakeholder view. A company like General Electric, for
example, recognizes explicitly a desire for a convergence between a shareholder and
stakeholder perspectives. That is looking for actions that are win-wins for both the
shareholders and other stakeholders. So there's a whole empirical literature on this. In
general, the findings are that firms that tend to do well, financially, they also do well by
having some attention to corporate social responsibility. Now the question is whether
they're intrinsically motivated to do that or whether they're extrinsically and
instrumentally doing it just because they know it helps their bottom line. But in some
ways, the answer to that question, it's not essential for the observation that companies,
whatever their motives that have corporate social responsibility, tend to have better
financial bottom lines.

To finish up this particular video, we'll look at the issues of corporate governance. So
you've heard this term probably a lot throughout the course. Here, let's formally define it.
The corporate governance represents the relationships among the stakeholders that is
used to determine and control the strategic direction and performance of the
organization. I referred to it also earlier as thinking about it as the rules of the game
within the corporation itself. What are the responsibilities and duties of the board of
directors and the managers, so forth? The other aspect is what are called agency costs.
An agency costs are that the principal is the one paying to have something done and
the agent is the one who does it and the question is, will the agent act in the interest of
the principal? We talked a little bit earlier about the separation of ownership and control,

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so there, the agent is the manager and the principal is the shareholders, and will the
manager act in the best interest of the shareholder? When they do not, that's referred to
as agency cost. So how do you reduce the agency cost? That is, how do you get the
ancient actually act in the way that the person who's paying wants them to act. So that
there are few ways to do that. One is to provide the agent with more incentives, and so
that'll be incentive cost. Another is the principal can monitor the agent's behavior more,
and so that will be monitoring costs. There can be penalties for non-compliance and
that's referred to as the enforcement cost. So let's take an example of a franchisor and
franchisee. The franchisor of McDonald's is the principal, and the franchisee of the
particular McDonald's store that you may attend is the owner of that particular store is
the franchisee. Now the question is, how do you get the franchisee to act in the benefit
of the whole system? Because if the franchisee does not, it will not only hurt that
particular restaurant, it may hurt the entire brand name of McDonald's if a customer has
a bad experience, and that one restaurant it may affect the whole system and word of
mouth with other people. Now in the era of social media, the need for control of quality
is even greater than ever. So McDonald's will use a mix of incentives, monitoring, and
enforcement within their franchise contract as a way to try and get better performance.
All of those costs that McDonald's incur and that franchisor-franchisee relationship are
called agency costs.

Now, there are different corporate governance mechanisms that can be used and we'll
talk more in our final video about some of these mechanisms. But just for now, the
different ways that the corporation tries to minimize the cost are referred to here as
mechanisms to direct and control the firm. The objective of these mechanisms are to
ensure the pursuit of the strategic goals of the company, that is they wanna do certain
things, how are they going to implement and get what they want. In particular, and
specifically we're addressing the principal agent problem. How do you minimize the
agency cost? How do you minimize the sum of the monitoring cost, the enforcement

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cost, and incentive cost within the organization? So at its larger level, what we're talking
about is if you have really good corporate governance. You're less likely to have
accounting scandals like we had at Enron, less likely to have global financial crisis. For
Bernie Madoff who was very well known or infamous, I guess, more than famous for
having a Ponzi scheme or a scheme that was a pyramid scheme of taking some money
to pay others to pay out. But you never really have enough money to cover and your
debt keeps getting worse as you go along. So that's a severe agency problem. In that
example, Bernie Madoff was just trusted by all the principals who gave Bernie Madoff
money, no one was checking the books, no one was monitoring him and so that really
gave him a lot of leeway for egregious behavior. The central concept at an abstract level
is that of asymmetric information. That is Bernie Madoff has all the information and
doesn't give any of it out, no one's monitoring him, and then he takes advantage of that
asymmetric information. Another example of asymmetric information is those who buy
and sell stock, who get inside knowledge within the accounts. It's not really a fair playing
field for buying and selling of stock, and there's insider information at some point will be
defined as illegal activity. If a person is caught with buying and selling with insider
information, then they have severe penalties for that.

Finally, to finish up this section, once again, we've been using the term agency theory a
lot. So agency theory then views the firm as a nexus that is a bundle of legal contracts.
So the employees have legal rights. The customers, when they buy a product, have
legal rights for having certain expectations. If you buy a ladder and the ladder collapses
and you get harmed, you may have strong recourse from the firm for compensation and
so forth. So there's relationships and thought of as contractual relationships among all
the stakeholders of the firm. Some are explicit contracts and some are implicit contracts,
but the law will treat them all as types of contracts that have their own sets of
responsibilities and obligations. When we talk about asymmetric information problems,
there's two types of agency problems in particular and one is called the adverse

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selection problem and the other is the moral hazard problem. Within the context of the
employment relationship and adverse selection problem is perhaps someone
misrepresents their abilities to the employer. So we're asking, are you an architect? The
person says, "Yes. I'm an architect," and they started then later on, they discovered they
don't actually have an architectural degree. That would be a misrepresentation. The
other type of thing that can happen is even if you are an architect, once on the job, if
there's any kind of slacking or shirking or not putting in very much effort, and that is
referred to as a moral hazard problem. So those will be two of the challenges. When we
finish up on our last video, we're talking about mechanisms to reduce asymmetric
information and agency problems and in particular, reducing these adverse selection
and moral hazard problems.

Lesson 1-1.3 Mechanisms of Corporate Governance

We've been talking, within this module, about agency costs and agency problems. This
issue has been around for a long time. As a matter of fact, Adam Smith In The Wealth
of Nations in 1776 asked about these questions. And then a very famous book in 1932
by Adolf Berle, who's pictured here, who was a law professor at the Columbia
University, and Gardiner Means was an economist. And so they came together and
wrote a book called The Modern Corporation. And on page 121 of that 1932 book, they
ask the question, have we any justification assuming that those in control of a modern
corporation will also choose to operate it in the interest of the stockholders? That's
essentially what in modern language is called the agency problem. So what we're going
to focus on now is what are the institutions of capitalism, or from the last set of slides
what we called mechanisms, which can lessen the problem of the separation of
shareholder ownership and the risk-bearing principles? That is, those who provide the

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money, but do not have the, from those who have control of the corporation, which were
those that are providing the managerial decisions within the corporation. Keep in mind,
this is the question, why do managers care about the profitability of their company or
division within the company?

The first mechanisms of why they should care if they're publicly traded company is if
they don't keep the stock price at a certain level, there's the threat that they may be
taken over. Or sometimes this is called the market for corporate control. So if the
company has egregiously poor management and people start selling off the stock, that's
the signal in the [INAUDIBLE]. Of course, there could to be many other reasons,
including the macroeconomy, and there's many other reasons besides poor
management about why stock price goes down. But if management is very poor, you're
certainly on the radar screen when the stock price starts dropping. People are going to
ask questions, why is that stock price decline occurring? The second reason why
managers would care about profitability, for example, of their division is that if they have
very good performance, then that's going to show up in the numbers. And then there is
a market for managers as well, so these executives may be recruited by other
companies. And on their resume, they might have that since they joined the
organization, they increased the performance of all these different measures and so
forth, as a signal of their quality. Now, of course, the catch to that too is the executives
may be manipulating the numbers, they might reduce the investment base of the
company. And then their ROA looks real great, but it's not because they were making
the income go up, they were actually making the asset base of the company go down.
It's that ratio of those two numbers. So the more discerning person evaluating a
manager will look at lots of different metrics to make sure that it's actually good

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performance by the manager. A third is, we talked before about the role of the board of
directors. Well, the board of directors is certainly in charge of evaluating the CEO and
top management team of the company. So the monitoring by the board of directors,
particularly in some corporations are more effective than others with their board of
directors. And that can also be a mechanism for reducing agency costs. A fourth is that
compensation can be heavily weighted toward stock options. Why should managers
care about the stock of the company? Well, they have lots of stock in the company.
Now, when I first heard that idea many years ago, I thought that was the no-brainer way
of solving the problem. Unfortunately, if you recall Enron a few moments ago or the last
video, which you may have seen very recently, the discussion there for Enron is that
those executives had tons of stock options. But a matter of fact, that gave them then the
incentive to manipulate the market to get the stock price higher in artificial ways. So in
other words, you solve one agency problem of managers don't care about the stock
price, and then you make the managers care a little bit too much about the stock price.
So there clearly needs to be Goldilocks principle somewhere in between that, that is
some intermediate range where you will get better performance in terms of
compensation of the managers. Another one is that if I'm an individual shareholder, my
shares are so small in the company, it's just not worth my time and effort to monitor the
actions of the company on a day-to-day basis. But if you're an institutional investor, then
you have a large amount of investments in the organization, then you may monitor very
closely. As a matter of fact, institutional investors will even call up the CEO if they're
displeased with a particular action of the managers and have a conversation with the
manager. So there, if shareholder interests are not attended to by the manager, there
will be feedback from the environment from large institutional investors. The next is
debt. If you're a manager in a company that has a large level of debt, you have no room.
Many years ago, RJR Nabisco had a tremendous number of corporate jets and plush
expenditures throughout the world for its top management team. And it was an era of
excess in many different ways. On the other hand, if you're a company that's on the
verge of bankruptcy, then you have no free cash flow to play with. And so that's going to
make you focus on being efficient and not being wasteful. That's on the plus side. But I
would also say that that mechanism is probably relevant if you're in the grocery
business. And what I mean by that is there's not a lot, it's very low profit margin biz, high
volume, but low profit margin business. And there's not a lot of room for really high net
present value or high economic return projects. And so therefore, being efficient in
exactly what you do is a good thing. On the other hand, if you're a high-tech company
and you're going to need a lot of free cash flow for the next big investment that maybe a
couple hundred million in R&D if you're in the pharmaceutical industry. Then if you have
a large amount of debt, you're not very well positioned. In other words, what I'm saying
is in some context, minimizing agency cost is not the primary problem. The primary
problem is being ready for the technology and the next big move you're going to make.

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And minimizing the agency cost of small potatoes relative to the problem of being
positioned for new technology. The economist Joseph Schumpeter was the one who
emphasized it's the new technologies that at the end of the day are the key for
companies. So while this whole section is on agency cost, keep in mind that it's a
problem in cases like Enron, and Tyco, and WorldCom, it gets out of control. But it's not
the only problem that managers have. The seventh mechanism is, in general, when you
have the chairperson and the CEO as two different people in the organization, then you
have the chairperson of the board of directors being the monitor of the CEO. Sometimes
when you have the CEO is also the chairperson of the board of directors, then the CEO
chairperson could be very influential in the board of directors, to the point where the rest
of the board is not particularly effective at monitoring the CEO. So if you're a company
like in the grocery business, so my takeaway, and this is just a conjecture that I'm giving
right now, is if you're in the grocery business. It's probably good to focus on minimizing
agency cost and to have a separation of CEO and chairperson. On the other hand, if
you're in a high-tech market where you need rapid decisions, maybe having a separate
chairperson CEO is going to slow you down. And you're not going to be there for the
new technology and you're going to be solving the agency cost problem, but you have
other things that are also maybe even more critical than that. So one of the things really
for the takeaway for this subject we call strategy, it's contextual, it depends on the
problem at hand. And furthermore, even the problem that is the right solution in 2016
may not be the right solution in 2018. The interesting thing I'll say about that is I get a lot
of feedback that these videos are things that we can leverage for multiple years. But the
reality in strategy is, strategy is always changing. So that the right answer in 2016, I
may have to be back here two years ago and be saying all the different areas that used
to work that no longer work. And that often happens. So the key phrase I would use is
strategy changes. And then finally, the last point, eight, is that we talked earlier in our
course about the multi-divisional. You can think of the multi-divisional is also why
managers care about profitability. If you have five divisions of a company and they're all
measured by the corporate staff in terms of return on asset, then they're all competing
with each other. And whatever numbers and metrics the corporate staff is using, they all
are being evaluated on those numbers. So of course, the managers are going to care
about those profitability metrics within their own division.

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Professor Deepak Somaya

So these are the eight major mechanisms of why managers will care about the financial
performance of the division or company that they're running. We also talked about the
directors, and we can talk here, drill down about some of the responsibilities that they
have. And the other thing I'll say about this slide is this is more normative than
descriptive. This is what the board of directors should be doing. If you look in particular
companies, they may be very far away from what they, what they actually do and what
they should do can be pretty dissociated or pretty far apart. But here are the functions of
the board of directors, selecting, evaluating, and compensating the CEO, overseeing
CEO succession plans, providing guidance on executives and their compensation.
Reviewing, monitoring, and approving the strategic initiatives, conducting a risk
assessment and mitigating those risk. As a matter of fact, for our last case for this
module, we're doing the BP case and the risk assessment they had in terms of the
Horizon disaster that occurred for BP. So in some sense, you can say that the board of
directors is also in some ways responsible for, or at least evaluating where were they in
terms of evaluating these plants. Next step is ensuring that the firm's audited financial
statements are done correctly. That's much more focus of the board of directors today
than 15 years ago. And finally, ensuring a firm's compliance with the laws and
regulations, which gets back to our pyramid discussion that we had earlier.

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Professor Deepak Somaya

Your question for discussion is, in 2011, there were 17 members of the board of
directors for General Electric, with a market capitalization of about $325 billion. 15
members were independent outside directors. One of the inside directors was CEO
Jeffrey Immelt, the Chair of the Board of Directors. In roughly two-thirds of US public
firms, the CEO of the company also serves as Chair of the Board of Directors. What
arguments can be made for and against splitting the roles of the CEO and the Chair of
the Board of Directors? Please reflect on this question and post your response in the
discussions for this video. Thank you.

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Professor Deepak Somaya

Finally, to finish up, we noted early in the first module for this or the first video for this
module that the different states in the United States can have different corporate
charters. The State of Nevada has a different corporate charter and different rules of the
game than the State of Delaware. We also can see that that governance is quite
different throughout the world. So we have what are called free market economies, but
there is no such thing as a perfectly free market economy. They're all hybrids, it's more
a matter of degree than in kind. So at one end of the market economy spectrum, you
can have state-directed capitalism, like China, where there's a lot of control. And on the
other hand, relatively speaking, a free market capitalism in the US, where there's more
freedom of the corporations. So going into the other countries then, some countries
have much more focus on, like stakeholder capitalism in Germany focuses on labor
representation on the board of directors, which is very rare in the United States. So the
interest not only of shareholders, but also labor. And the balance and the trade-off
between are discussed within people who sit at the table of the board of directors in
Germany. France has a lot of state-owned enterprises, and it's another type of
stakeholder capitalism. And then finally, as we mentioned, China has state-owned
enterprises, where they often will be involved in the strategic plans of those companies
in addition to the CEO of that company.

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Professor Deepak Somaya

Lesson 1-1.4 Recent Developments

In recent years, there have been some significant changes in how companies have
responded and adapted to the shareholder-centric worldview that many corporations
have operated in. These changes can largely be seen as responses to problems arising
from two interlinked challenges. First, an over-emphasis on shareholders and their
interests, such as generating a higher return on equity. Second and equally important,
there's a significant concern about too much emphasis on measurable short-term
financial metrics that are primarily financial.

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Professor Deepak Somaya

In response to these challenges, modern companies have done a number of things.

First, they have sought to explicitly broaden their mission to include such things as
corporate social responsibility and sustainability goals. So these companies are
explicitly putting shareholders on notice that they are going to pay attention to a set of
other stakeholders as well. Moreover, they will be paying attention to some of the long-
run impacts through sustainability goals for example, of the companies actions. Many
companies have now set themselves the goal of being carbon neutral in their
operations, for example, in response to the climate crisis. Many companies have also
adopted performance measurement systems such as the balanced scorecard that go
beyond short-term financial or accounting metrics. The balanced scorecard, which has
become extremely popular in business, includes metrics related to customers,
operations, and the organization in addition to financial metrics in order to provide a
more holistic performance and health assessment of the company. I will not get into a
detailed overview of the balanced scorecard here. There are many excellent online
resources for this, but I want to emphasize for you again that it incorporates the
interests of multiple stakeholders and consideration of the long-run health and success
of the company.

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 Corporate Strategy
Professor Deepak Somaya

Another important development has been the rise of ecosystem strategies or ecosystem
thinking in business. The idea of a business ecosystem was introduced first in an article
by James Moore in the Harvard Business Review in 1993. Moore's core idea was that
firms should not be viewed simply as members of an industry, but as members of a
business ecosystem, comprising of various interacting organizations and individuals
such as suppliers and complementors and even government entities and customers.
Within this broad ecosystem, cooperation and partnership with others, which we can
now think of as stakeholders, are especially important for the long-run success of
companies. There are many examples of such business ecosystems that one can think
about. Shopping malls is an old example, but ecosystem thinking has become
especially important for highly successful technology enabled businesses that have
taken the form of platforms.

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 Corporate Strategy
Professor Deepak Somaya

Whether you think of Google, Amazon, Facebook, Apple, or Alibaba, all have created
businesses where multiple other players interact with each other on their platform in
order to create value. Even Coursera as an online education platform, essentially has
the same platform based model. In all these cases, the companies have to carefully and
consciously think about all the stakeholders they need to bring together within their
ecosystem. How to attract them, how to keep them committed, how to balance their
different interests and goals, and how to ensure that the ecosystem as a whole
continues to provide value and out-compete others.

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 Corporate Strategy
Professor Deepak Somaya

In short, ecosystem strategies are at the bleeding edge of modern stakeholder

management, which can be seen in the ongoing rapid growth of the use of the term
ecosystem in business press coverage as can be seen in this graph.

Another response from managers to the dilemma of shareholder-centric capitalism has

been to seek some degree of protection from not for shareholders. The more traditional
approaches to this include things like poison pill provisions, which make it difficult and
costly for shareholders to replace the company's management. For example, in 2012,

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Professor Deepak Somaya
Netflix's board adopted a poison pill whereby the company would issue a large number
of shares in the market if any shareholder acquired more than, say a 10 percent stake in
the company. At the time, the company was being pressured by Carl Icahn, a well-
known activist shareholder who had been buying up shares of Netflix and wanted the
company to focus a lot more on short-run profitability. Another common approach in
recent years has been to take the company private, so as to shield it from the whims
and pressures of the public financial markets. This has of course led to huge growth in
the private equity industry. Another place the same approach of shielding companies
from the public markets are surfaced is in the rise of so-called unicorns. Unicorns are
startup companies with valuations that exceed a billion dollars, and our callback
because they're supposed to be extremely rare. But in recent years, the availability of
cheap funding and the desire on the part of company founders to avoid shareholder
scrutiny has led to a flood of unicorns. What was supposed to be a rare phenomenon
has now become very common indeed. Last but not least, even in public companies,
we're increasingly seeing two classes of shares, where the publicly traded version has
fewer voting rights, and the voting rights are closely held by a core group that typically
includes the founders of the company. This group typically have a set of so-called
preference shares. The idea here is that these founders will serve as the guardians of
the long-term interests of the company and act in good faith to protect these long-term
interests. But there are significant concerns about these approaches as well. Both the
large quantities of private equity that are not subject to the market test are being vetted
by multiple analysts and investors, and the reliance on founders and their ilk to
somehow protect the firm's value. The spectacular collapse of Wework's IPO is a
cautionary tale that these approaches to dealing with shareholder primacy may have
significant downsides as well.

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Professor Deepak Somaya

Wework's largest investor SoftBank had to pay over a billion dollars to buy out founder
CEO Adam Newman's dual class shares,

which gave him the majority of votes on the board in order to eventually take control of
the company, and it is still not clear how much value there is in Wework. The general
consensus seems to be that SoftBank and other private investors likely made a huge
loss on their investment. That brings to a conclusion this module as well as this MOOC
on corporate strategy. I hope it has been a fun and rewarding experience for you as it

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Professor Deepak Somaya
has been for me in putting it together. I hope you've learned a lot of things that will be
useful to you, and don't forget to share the light on knowledge with others. As Master
Yoda wisely says, "Pass on what you have learned." I look forward to seeing you again
in the course.

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