governance challenge.
INTERNAL GOVERNANCE
Although corporate executives are responsible for making a myriad of strategic decisions that contribute to a firm's competitiveness and performance, their choices are constrained by internal corporate governance actors such as the board of directors and employees. While much has been written about internal governance, especially about boards, no systematic analysis exists on how internal governance actors influence strategic decisions. We examine relatively unchartered territory by examining the actors' impacts on decision-making, beginning with an analysis of the different board attributes and tools that directors use to govern firm executives and shape decisions. Our discussion will include a look at how employees, as another important internal stakeholder, can also shape corporate governance and strategic decisions.
Corporate governance, though more challenging than in the past, is critical to firm success. Under its scope, directors make the vital decision of selecting an appropriate CEO to guide the strategic direction of the firm. If the board makes an unwise choice, not only in selecting but also in setting the compensation of the strategic leader, shareholders and stakeholders all suffer. As such, effective leadership succession plans and appropriate monitoring and direction-setting efforts by the board of directors contribute positively to a firm's performance. Boards face unforeseen circumstances, as in the need to replace a CEO due to financial misconduct. In this case, research shows that directors tend to choose a successor with a degree from a religious university, since such a choice has been shown to reduce the likelihood of misconduct.12 Similarly, when KPMG, one of the big four accounting firms, was questioned by the Internal Revenue Service and found culpable of engaging in inappropriate tax shelters for years in the late 1990s and early 2000s, the directors of the company hired a new CEO, appointed a former judge onto its board, and established board committees focused on fostering better professional ethics and risk compliance norms through its operations committee. Likewise, they pursued vigorous ethics and risk training for all employees.13 Their efforts saved KPMG from suffering a fate similar to Arthur Andersen, a former “Big Five” accounting firm that ceased to operate due to the Enron fiasco.
In addition, choosing an outside versus an inside CEO (one who is currently employed at the firm) can lead to more strategic risk taking for the organization, but such increased risk taking can result in performance extremeness.14 Increased strategic risk taking is analogous to swinging for the fence in baseball (trying to hit a home run). Although Babe Ruth set home run records, he also set record strikeouts at the plate. Appropriate executive compensation also influences risk taking. Too much emphasis on CEO stock options leads to excessive strategic risk taking and can lead to some good performance, though poor performance (striking out) is more likely.15
PURPOSES FOR BOARDS OF DIRECTORS
A board of directors is a group of individuals elected by shareholders whose primary responsibility is to act in the best interests of stakeholders, particularly owners, by formally monitoring and controlling the firm's top-level managers. Board members reach their expected objectives by using their powers to set strategies and policies for the organization and reward and discipline top managers. The work of boards, though important to all shareholders, becomes especially important to a firm's individual shareholders with small ownership percentages since they depend heavily on the directors to represent their interests.
Unfortunately, evidence suggests that boards have not been highly effective in monitoring and controlling top-level managers' decisions and subsequent actions.16 This problematic conclusion may be even more prevalent in emerging-market countries. However, large differences exist in the arrangement of governance systems between developed and emerging markets around the world. The Strategic Governance Highlight (Box 1.2) provides an illustration of how boards conduct strategic governance in Europe, Japan, and China. Although insider-dominated boards still prevail in much of the world, the trend is changing, especially in developed countries like Germany and Japan, but also in emerging market countries like China.
As noted earlier, among emerging countries and historically in the United States, inside managers dominate boards of directors. Yet, we concur with the widely accepted view that a board with a significant percentage of its membership composed of the firm's top-level managers provides relatively weak monitoring and control of managerial decisions. Under such a board, managers sometimes use their power to select and compensate directors and exploit their personal ties to implement strategies that favor executive interests. In 1984, in response to this concern, the New York Stock Exchange (NYSE) implemented a rule requiring outside directors to head the audit committee. Subsequently, after the SOX Act was passed in 2002, other new rules required that independent outside directors lead important committees, such as the audit, compensation, and nominating and governance committees. Policies of the NYSE now require companies to maintain boards of directors that are composed of a majority of outside independent directors, as well as to maintain fully independent audit committees.
But while the additional scrutiny of corporate governance practices has led boards to devote significant attention to recruiting quality independent directors,17 the emphasis on outside directors has led to 40 percent of boards having only one inside manager on the board: the CEO. This scenario produces another less-than-ideal dynamic that leads to less monitoring of executive decisions by the board,18 since monitoring becomes more focused on financial control rather than strategic control, especially without sufficient insider managers to properly inform the outside members about the intricacies of long-term strategic decisions and how they are implemented.19 In fact, such boards (with the CEO as the only insider) pay the chief executive excessively, have more instances of financial misconduct, and have lower performance than boards with more than one insider.20 Boards should seek balance to be sufficiently knowledgeable and achieve the most effective approach to fulfilling their purpose over time in representing stakeholder interests. Next, we take a closer look at board characteristics, monitoring, and setting executive compensation to further understand strategic governance.
BOX 1.2 Strategic Governance Highlight: Boards in Europe, Japan, and China
Corporate governance is of concern to individual firms as well as nations. Although corporate governance reflects company standards, it also collectively reflects the societal standards of countries. Standards are changing, even in emerging economies, such as in the level of independence of board members to enact practices for effective oversight of a firm's internal control efforts. Since firm leaders seek to invest in countries with national governance standards that are acceptable to them, especially when expanding geographically into emerging markets, national governments pay attention to corporate governance.
German firms with more than 2,000 employees are required to have a two-tiered board structure that places the responsibility of monitoring and controlling managerial (or supervisory) decisions and actions in the hands of a separate group. All the functions of strategy and management are the responsibility of the management board. However, appointment to management falls under the responsibility of the supervisory tier, while employees, union members,
